BUSINESS FINANCE 

A Practical Study of Financial Manage- 
ment in Private Business Concerns 



BY 

WILLIAM H. LOUGH 

President, Business Training Corporation, 
New York City; formerly Professor of 
Finance, New York University School of 
Commerce, Accounts and Finance; Author 
of ''Corporation Finance," "Lectures on 
Panics and Depressions," "Banking Oppor- 
tunities in South America," etc. 



STUDENTS' EDITION 




NEW YORK 

THE RONALD PRESS COMPANY 

1917 



H/7 



Copyright, 1917, by 
The Ronald Press Company 




William G. Hewitt Press, Brooklyn, Printers 
J. F. Tapley Co., New York, Binders 



©CI.A462676 



PREFACE 

This book, as its name indicates, is concerned with the 
every-day financial problems of the private business concern. 
The point of view taken throughout is that of an organizer 
or financial manager of an enterprise. While the book deals 
primarily with business conditions and financial practice in 
the United States, it includes many references also to the ex- 
perience and practice of other countries which may yield 
suggestions of value to American business men. 

Many social and economic questions are necessarily 
touched upon incidentally. These questions, however, in the 
author's judgment, belong to a separate field of study; no 
attempt is made, therefore, to discuss them at any length. 

The subject matter of the book falls naturally into five 
distinct parts : 

Part I begins with a brief exposition of the essential 
principles of all sound financing; it is devoted for the 
most part to a description of the different forms of finan- 
cial organization of business enterprises, taking up in turn 
the individual proprietorship, the firm or partnership, and 
the corporation. 

Part II discusses the various forms of security issues 
and the manner in which they may be combined and or- 
ganized as determined by the basis of capitalization of the 
particular enterprise. 

Part III treats of the methods of raising capital 
through the sale of securities and the usual forms of 
promotion and underwriting. 

Part IV deals with efficient financial management; how 
capital funds are invested; how the amount required for 
working capital is ascertained; the proper management of 

iii 



i v PREFACE 

capital and income through budgets; and some of the 
financial standards which should be kept in view. 

Part V treats of financial mismanagement and irregu- 
larities, and of the processes of reorganization. 

This very brief review is enough to make clear the main 
purposes of the book and the groups of business men to whom 
it is designed to prove useful. 

The first group, whom the author has had constantly in 
mind, consists of organizers, directors, and executive officers 
of business concerns of all classes. It is hoped that they will 
obtain from the book many helpful suggestions which they 
can put to practical use. 

The second group consists of bankers, bond dealers, and 
other financial men who are continually investigating and 
criticizing the financial management of enterprises. 

There is a third group, composed of engineers, lawyers, 
accountants, and other professional men, who are frequently 
called upon to advise as to financial questions, although they 
are not necessarily well informed on these subjects. 

The present edition is specially intended for a fourth 
group — which fortunately for the business of the country 
is rapidly growing in numbers — made up of students of 
business and economic subjects, including not only those en- 
rolled in universities or other institutions of learning, but also 
the tens of thousands of young business men who realize 
that long continued study is required in order to achieve 
even a reasonable mastery of the intricacies of modern 
business. 

For the use of this group the practical material contained 
in the first four parts of the general edition of this work has 
been retained in full detail and with all supporting illustra- 
tions, save in the chapters discussing budgets and financial 
standards. Here, where the subject is comparatively new and 
practice is unsettled, much of the theory and illustration has 



PREFACE v 

been dropped. In Part V, where detailed information is not 
of the same vital importance to the student, the more essen- 
tial features have been retained, but much of the illustration 
and some of the discussion have been omitted. 

Literature on the subject of business finance is so scanty 
that the present book necessarily breaks fresh ground to a 
considerable extent, and this must be the author's excuse if 
sometimes the treatment of a topic seems to be incomplete. 
This remark applies with special force to the chapter on 
"Financial Standards'' — a subject to which a great amount 
of research could profitably be devoted. 

William H. Lough 
New York City, 

April 9, 1 9 17. 



CONTENTS 



Part I — Finance and Business Organization 

CHAPTER PAGE 

I Principles of Financing i 

II Forms of Business Enterprises 1 1 

III The Corporation 25 

IV The Corporate Form — Advantages and Disad- 

vantages 45 



Part II — Capital 

V Owned Capital 64 

VI Borrowed Capital — Short-Term 105 

VII Borrowed Capital — Long-Term 130 

VIII Basis of Capitalization 172 



Part III — Securing Capital 

IX Sources of Capital Funds 201 

X Promotion 229 

XI The Promoter 250 

XII Promoting Combinations 265 

XIII Selling Securities Direct 291 

XIV Selling Securities Through Dealers 319 

XV Underwriting 339 

vii 



viii CONTENTS 

Part IV — Internal Financial Management 

CHAPTER PAGE 

XVI Investment of Capital Funds 355 

XVII Calculating Requirements for Working Capital. 380 

XVIII Determination of Net Income 415 

XIX Dividends 435 

XX Surplus 465 

XXI Budgets 482 

XXII Financial Standards 489 



.Part V — Financial Abuses and Involvements 

XXIII Exploitation by Officers 499 

XXIV Exploitation by Directors and Majority Share- 

holders 507 

XXV Insolvency and Receivership 514 

XXVI Reorganization 529 



BUSINESS FINANCE 

Part I — Finance and Business Organization 



CHAPTER I 

PRINCIPLES OF FINANCING 

Scope of Subject 

In this volume is considered the subject of securing and 
handling money and credit for business enterprises. If these 
terms were used with strict accuracy, the statement might be 
shortened by leaving out the reference to money; for, after 
all, credit in one form or another is almost the only element 
with which we have to deal. But it is not necessary here to 
enlarge upon these technical limitations. 

Financing deals, first, with the raising of the initial capital 
needed for business enterprises, what securities to issue, how 
and to whom they should be sold, how best to utilize the 
funds thus secured, together with their proper apportion- 
ment for plant, equipment, and working capital; second, with 
the accurate determination of profits and their allocation to 
dividends, surplus, sinking fund and reserves, and the en- 
largement of capital permanently invested. It is concerned 
with the forecasting of business development and resulting 
financial needs and with provision for the business equivalent 
of a "rainy day." 

Unskilful Business Financing 

Financing is, perhaps, the least understood subject in the 
field of business, not even excepting accounting. A great 

I 



2 FINANCE AND BUSINESS ORGANIZATION 

many men have proved themselves able and successful as 
producers, organizers, and sellers, but have failed utterly in 
handling their financial problems. 

A conspicuous example was the late Mr. George Westing- 
house, the brilliant inventor, organizer, and salesman who 
founded the Westinghouse Electric and Manufacturing Com- 
pany, the Westinghouse Air Brake Company, and other en- 
terprises. Mr. Westinghouse made a success of every busi- 
ness enterprise he touched except in so far as financing was 
concerned. He apparently was not familiar with financial 
methods and did not possess the foresight to keep his enter- 
prises properly provided with cash as they progressed. Con- 
sequently, he was twice faced with serious embarrassment 
and in the end was compelled to relinquish the management 
of the Westinghouse Electric and Manufacturing Company. 

This case is not an uncommon one. In fact, it is quite 
generally true that men of an optimistic, emotional turn of 
mind who make good as producers and salesmen are just the 
men who deceive themselves as to their own financial affairs 
and often wreck a promising business on some financial reef. 

It is surprising to find how many directors of important 
corporations give insufficient attention to the basic financial 
problems of corporate business. Frequently insolvency, which 
should have been clearly foreseen, comes upon a board of 
directors when they fancy their company to be at the height 
of prosperity. This was true, for instance, of the insolvencies 
during recent years of the National Cordage Company, the 
American Malting Company, the National Asphalt Company, 
the United States Realty Company, the New England Cotton 
Yarn Company, and the Westinghouse Electric and Manu- 
facturing Company. 

Among smaller concerns the amount of ignorance regard- 
ing financial management is even greater. Every experienced 
business man probably has observed instances where profitable 



PRINCIPLES OF FINANCING 3 

enterprises were half developed and then abandoned for lack 
of funds, when, in nine cases out of ten, the whole financial 
process might have been figured out in advance and the neces- 
sary funds raised with little difficulty. Instead, the enterprise 
too often drags out a painful existence for a few months or 
a few years, eats up the owner's capital, and at the end leaves 
him a poorer, but not always a wiser, man. 

Financing and Accounting 

Poor financing is apt to be combined with poor account- 
ing; and in that case the unfortunate owner cannot enjoy 
even the empty satisfaction of a post-mortem diagnosis. 

This brings up a question on which there has been much 
confusion of thought — the question as to the dividing line 
between the subject of financing and the subject of account- 
ing. It is not purely an academic question, for in many busi- 
ness concerns the head of the accounting department and the 
head of the financial department are continually treading on 
each other's toes. Or, a still worse thing happens; the two 
offices are combined under the management of one person. 

There is undoubtedly a twilight zone between the two 
subjects. When we come to discuss rates of depreciation, 
sinking fund requirements, valuation of good-will, and the 
like, we shall be in constant danger of trespassing into ac- 
counting territory; while, on the other hand, our friends the 
accountants, especially public accountants, have not hesitated 
to make many bold forays into financial fields. Frequently 
they are called upon to advise their clients as to securing 
bank loans, the proper types of bonds and shares to issue, the 
proper investment of capital funds, the declaration of divi- 
dends, and so on. However, bankers, treasurers of corpora- 
tions, and finance committees are becoming more and more 
successful in repelling these incursions, thus restricting the 
accountant to his proper activities. 



4 FINANCE AND BUSINESS ORGANIZATION- 

We need not enter into the technicalities of the friendly 
controversy. A broad distinction, however, between the two 
fields of work and study may easily be made. Accounting, 
properly speaking, deals with recording and analyzing results 
that have been achieved ; and its growing value and popularity 
is due to the general recognition that the conclusions drawn 
by skilled accountants may profitably be used as a foundation 
for future action. 

Financing, on the other hand, deals not with recording 
and analyzing but with getting positive results; how to raise 
money for various business enterprises; what securities to 
issue; to whom they should be sold; and how to use the pro- 
ceeds to the best advantage for the promotion of the business. 
These are some of the typical problems clearly outside the 
scope of accounting which are discussed in this volume. 

Two sister subjects in the field of finance are investing and 
banking. Investing deals with the process of supplying capital 
to business and public undertakings for their permanent use, 
that is, as original investments or for long-term loans. Bank- 
ing deals with the process of supplying capital to these enter- 
prises for their temporary use, that is, for short-term loans 
exclusively. Both of these processes are referred to frequently 
but they are of so much importance that they will be treated 
separately. (See Chapters V, VI.) It may be noted that 
both investing and banking deal with supplying credit, while 
financing deals with obtaining and using credit. The same 
problem is involved in both but is treated from different points 
of view. 

Public Financing and Business Financing 

Another cognate subject, which is, however, outside the 
scope of this book, is public financing, which deals with the 
securing and handling of money and credit for governments — 
national, state, and municipal. 



PRINCIPLES OF FINANCING £ 

Public financing has been much studied and written about ; 
many valuable books have been published on such subjects 
as taxation, governmental loans and their repayment, regula- 
tion of governmental expenditures, and the like. Business 
financing, on the other hand, has been surprisingly neglected; 
there are only about a dozen books and a few magazine ar- 
ticles devoted wholly to this subject, though, of course, a 
great deal of valuable information may be gleaned from mis- 
cellaneous publications. 

Yet the relative importance of the two subjects — public 
financing and business financing — seems to be in inverse ratio 
to the amount of study that has been given to each. 

In 19 1 2, according to the United States Census, the total 
value of all the property existing in the United States was 
approximately $187,000,000,000, of which $12,000,000,000 
or 7% was exempt from taxation and $175,000,000,000 
or 93% was taxable. Making reasonable allowances for the 
property of religious, educational, and philanthropic institu- 
tions in the tax-exempted classification, there remains only 
3% to 5% of the wealth of the United States that is directly 
owned by national, state, and municipal governments. Against 
this there is 93% owned and managed by individuals, firms, 
or corporations. On its face the comparison indicates that 
the neglected subject of business financing is worthy of 
thorough and careful study. 

There are probably two chief reasons, both inadequate, 
why business financing has been comparatively overlooked. 
One is the false notion, prevalent until recent years, that 
private business is a simple activity unworthy of serious con- 
sideration by intellectual men. Another reason is that data 
concerning methods of business financing methods are not 
conveniently assembled in volumes or in reports or statistics, 
but must be gathered, in large part, at first hand from active 
business men and from general business experience. As time 



6 FINANCE AND BUSINESS ORGANIZATION 

goes on, the subject will doubtless be more fully investigated 
and more information will be made available. 

It will become evident as we proceed that financing is 
related also to other business subjects, such as production, 
selling, organization, etc. ; but there is no confusion in its 
relation to these subjects and no necessity for explanation. 

Simplicity of Business Finance 

It is popularly supposed that many difficulties are en- 
countered in solving the problems of business finance. One 
writer even has defined the science of business finance as "the 
modern black art," as if it were something mysterious and 
uncanny. Yet, whatever may be said of the difficulties per- 
taining to actual practice, the essential principles of business 
finance are simple and can be readily understood by anyone. 
This can be illustrated by the close analogy existing between 
the financial problems of the business enterprise and the finan- 
cial problems encountered by the ordinary individual in his 
daily life. 

The individual possesses both tangible and intangible 
assets. He has money, tools, land, and other material things. 
Also, he possesses health, skill, knowledge, and other assets 
that are intangible. Business divides its assets into things 
tangible and intangible in the same way ; its plant, equipment, 
stock, and cash being tangible assets ; while its good-will, trade 
name, patents, and copyrights are intangible assets. 

The individual has his capital and his income and from 
these he must take his expenditures: first, to keep himself 
in condition to do business ; second, to increase his productive 
and consequently his earning power ; third, to reserve a portion 
of his income. He knows the laws of thrift and prudence, and 
knows that if he will obey them he will prosper. 

It will be shown that precisely the same kind of wisdom 
and foresight is required to invest properly the capital and 



PRINCIPLES OF FINANCING 7 

income of a great business so that it shall- continue to grow 
and prosper and shall not be short of funds and credit should 
an evil day unfortunately come. The business, great or small, 
that does not keep its expenditures within its income is as 
certain to come to grief as the individual who spends more 
than he earns. 

An individual should, from time to time, take an inventory 
of his resources and liabilities, physical, intellectual, and 
spiritual as well as material, and thus determine whether he 
is becoming richer or poorer. In like manner, every business 
should, at regular intervals, take an inventory, balance all ac- 
counts, subtract losses and add gains, and thus ascertain 
whether it is gaining ground or falling behind. 

Borrowing Money 

All our greater businesses are conducted largely with bor- 
rowed money; and in this matter we may carry our analogy 
with the individual yet further. It is well to remember, how- 
ever, that in borrowing for a legitimate purpose we are not 
engaged in that shiftless borrowing condemned by sages and 
moralists. Polonius said: 

Neither a borrower nor a lender be ; 

For loan oft loses both itself and friend 

And borrowing dulls the edge of husbandry. 

But this was not said in reference to borrowing or lending 
money for profitable business purposes. 

When a young man makes a long-term loan and pays 
interest on it in order that he may take a college course or 
prepare for a profession, he is not acting foolishly but wisely ; 
for the money will bring him a wealth of skill and knowledge 
that will enable him to repay both loan and interest, and dur- 
ing his life the transaction will increase both his usefulness 
to society and his earning power. In the same way, when a 



8 FINANCE AND BUSINESS ORGANIZATION 

business concern can borrow money to enlarge its plant, make 
needed improvements, develop the enterprise, and increase 
its profits, such borrowing is not only permissible but com- 
mendable. 

There are, however, some obvious limitations which will 
at once be recognized. No individual should borrow money 
unless it can be used to advantage and repaid promptly when 
it falls due. For this reason, short-term borrowing is usually 
not good business for either an individual or a business unless 
it is to "swing" some transaction that can be quickly com- 
pleted, or to tide over a brief stringency. 

Permanent and Transient Investments 

We can carry our analogy still further. All business 
assets belong in one or the other of two classes: those that 
are fixed and permanent, and those that are temporary and 
designed to be converted into cash within a short time; the 
first class is known as "fixed assets" and the second as "work- 
ing assets." In every business there should be a proper pro- 
portion between the amount invested in fixed assets and the 
amount reserved for working assets. 

Both the individual and the business concern often fail to 
observe the necessary proportions. Not infrequently an agri- 
culturist buys more land than he can profitably work and we 
have a "land poor" farmer. Many country merchants buy 
more stock than they can immediately sell. The less salable 
portion becomes shopworn and, as a consequence of this need- 
less tying up of money, they are without funds to replace 
the more salable articles. Many businesses, both great and 
small, have met disaster because the necessary amount of 
working capital was not correctly estimated, too much being 
invested in plant and equipment and an insufficient amount 
being left to conduct the business. 

It is always advisable to possess an emergency fund or 



PRINCIPLES OF FINANCING g 

some quickly convertible assets. From time to time, oppor- 
tunities offer which can only be taken advantage of by the 
possessor of ready cash, and when this propitious chance 
occurs the forehanded business man can act quickly and 
profitably. 

Application of Income 

Both the individual and the business concern possess a 
certain income from which living or supporting expenses must 
be drawn; therefore, to both the individual and the business 
concern comes the question of how much of the income may 
properly be utilized for non-paying purposes, such as pleasure 
in the case of the individual and dividends in the case of the 
business concern. 

At the beginning of each year the individual should esti- 
mate his needs. The business establishment should, in like 
manner, determine what amount of earnings should be set 
aside for a reserve, what should be applied to each depart- 
ment for maintenance, depreciation, etc., and whether an in- 
crease or curtailment of income may be expected. Item by 
item, this estimate should be scrutinized to learn where an 
outlay may be profitably curtailed, or where an outlay may be 
made for ultimate benefit. Such a proceeding is a practical 
method of planning finances; it can, and should be, con- 
sistently followed. 

Elementary Rules of Financing 

The following elementary rules of business finance apply 
alike to individuals and to the largest enterprises; the re- 
mainder of this work consists practically of the application 
of these general rules to various business problems. 

i. Study and utilize all sources of capital, including 
earning power and credit. 



IO FINANCE AND BUSINESS ORGANIZATION 

2. Do not be afraid to borrow for legitimate business 

development when you can earn profits and repay 
the loan when due. 

3. Do not dissipate capital on side lines and outside in- 

vestments. 

4. Systematically accumulate assets, both tangible and 

intangible. 

5. Always keep available sufficient cash and convertible 

assets to meet emergencies and to seize special 
opportunities. 

6. Use income sparingly for living expenses and pleasure, 

but freely for business maintenance and develop- 
ment. 

7. Use foresight — which is the cardinal virtue in all 

financial operations; make budgets to govern all 
expenditures. 

These are the prudent, indisputable rules for sensible 
financing. They have been preached and proven over and 
over again for many centuries past. The wisdom which 
these homely rules embody applies just as truly to the business 
of the Standard Oil Company and the United States Steel 
Corporation as to the affairs of John Smith. A man who 
can grasp these principles, hold them continually before his 
eyes, and apply them intelligently, is bound to handle his 
finances wisely both in his business and in his private life. 

However, simple as they are, to apply these fundamental 
principles to all the complex situations which arise in modern 
business is no easy task. Sound financing calls for clear think- 
ing and a wide range of knowledge. 



CHAPTER II 

FORMS OF BUSINESS ENTERPRISES 

Basic Types of Business Organization 

Throughout the world, wherever business enterprises are 
carried on, there are to be found three basic forms in which 
the ownership of these enterprises is held. 

1. The individual owning outright his own business and 

usually managing it himself without much co- 
operation or assistance. 

2. A group of owners, working together under some 

form of partnership agreement. 

3. The impersonal owner — the corporation — standing 

between the business and the individuals who have 
various kinds and degrees of claims upon the busi- 
ness. 

These three basic forms are combined and recombined in 
many different ways under the laws and customs of the 
various commercial countries, but analysis always reveals one 
or the other of the three forms predominating. 

This is shown by the short description, which has been 
added, of three other forms of business organization not often 
used but of interest, as showing how difficult it is to get away 
from the basic types. These are the limited partnership, 
the joint-stock company, and the association under deed 
of trust. 

The first two of these basic forms — sole proprietorship and 
partnership — represent the personal relationship of a man or 
a group of men to the business; but the third form, which 
is a comparatively modern invention, separates the owner or 

11 



I2 FINANCE AND BUSINESS ORGANIZATION 

owners from the business and brings into being an impersonal, 
intangible thing — a corporation — in which the nominal owner- 
ship is vested. 

It has been pointed out by writers on economics that there 
are three elements that must be distributed under any form of 
ownership; these three elements are risk, income, and man- 
agement. In the individual proprietorship the three are cen- 
tered in one man who risks his own capital, undertakes the 
management, and receives all the income. Under the partner- 
ship form, the partners as a body, like the individual owner, 
undertake the risk and management and receive the income; 
but among themselves there may be an infinite number of 
combinations. One partner, for instance, may supply all of 
the capital; another may supply the management; and they 
may divide the income in any manner agreed upon. Under 
the corporate form the risk is taken by the various creditors 
and shareholders who supply capital under the conditions that 
have been agreed upon. These creditors and shareholders 
divide the income in rough proportion to their risk. The 
management, however, is not necessarily retained in the 
hands of the people who contribute the capital, but may be 
turned over to directors and officers who are not personally 
large shareholders. The tendency has plainly been to separate 
the supplying of capital for the business and the management 
of the capital so that they need not necessarily be joined in 
one man or even in a small group of men. 

Sole Proprietorship 

The first of the three basic forms of business organization 
— the sole proprietorship — is the simplest and is even yet the 
most numerous. Small shops, farms, professional activities, 
and the like, are usually owned and conducted by one man. 
The owner does not separate his ownership of the business 
from his management of it; he does not even separate the 



FORMS OF BUSINESS ENTERPRISES 



13 



ordinary management of his business affairs and the manage- 
ment of his personal affairs. He, himself, is the business and 
the business is a part of him. 

The simplicity of this form does not necessarily imply, 
however, that it is applicable only to a small business. Many 
men of great wealth could properly regard the investment and 
management of their funds as itself a business, for this work 
alone sometimes requires the services of a force of assistants, 
bookkeepers, and clerks. Then, again, an individual may 
embark upon a business enterprise which grows rapidly from 
year to year and becomes very extensive; yet the original 
proprietor may continue to own and direct it all. This was 
the case, for instance, up to a few years ago with the great 
department stores in Philadelphia and New York which were 
personally owned and managed by Mr. John Wanamaker. 
However, it usually happens that a business which is becom- 
ing large and prosperous finds the single proprietorship un- 
desirable. 

The sole proprietorship has a real advantage in the ease 
with which a business may be started in this form, and a 
slight economy due to the absence of all legal agreements. A 
forceful man can often, by reason of his freedom from any 
restraint, make rapid growth under this form. A young man 
who starts his own business in his own name learns business 
management as the business grows, masters the difficulties of 
financial problems as he solves them, and becomes an all-round 
business man, with initiative, ability, and resourcefulness, by 
the natural evolution incident to his situation. Many of the 
biggest businesses and very many of the biggest business men 
in this country have developed along the lines of sole pro- 
prietorship. 

Its chief disadvantages are three in number. First, the 
capital of the business is limited to whatever the owner pos- 
sesses or can borrow. Some kinds of businesses, if they grow 



H 



FINANCE AND BUSINESS ORGANIZATION 



at all, will finance themselves, so that there will never be need 
for any more capital than was devoted to the business at 
the start; but the great majority of business concerns which 
are expanding require fresh capital. 

A second and even more serious disadvantage is the strict 
limitation on the management of the business. The owner 
must depend for all executive work either solely upon his own 
efforts or in part upon the efforts of men whom he engages 
at a fixed salary. Men of real executive ability ordinarily 
prefer to go with concerns in which they themselves have an 
interest in the business. If the individual owner wishes to 
secure the services of these men, the salaries he pays must 
be exceptionally high. To refer again to the case of John 
Wanamaker, it is reported that when he was getting started 
in Philadelphia, there were at least a dozen of his employees 
who were drawing much larger incomes from the business 
than was the proprietor himself. 

The third disadvantage, as compared at least with the 
corporation, is the ever-present personal liability of the owner 
for all the debts of his business. He cannot legally separate 
his personal property from that devoted to his business. 

The Partnership 

Fundamentally, there is no essential difference between the 
sole proprietorship and the partnership, except that in the 
second case a group of owners take the place of the individual 
owner. There may be any number of partners and among 
themselves they may have many different forms of agreement. 
The agreement must be, of course, between parties competent 
to contract. Partners are not necessarily equal, by any means, 
in respect to their investment of capital or as to their division 
of the income. Sometimes one partner receives a larger pro- 
portion of the income than corresponds to his investment of 
capital in order to compensate him for a special contribution 



FORMS OF BUSINESS ENTERPRISES 



15 



that he may be in position to make to the husiness, such as 
valuable experience or connections, or unusual business ability. 
A partner may not desire to have much capital in the business 
or even to be known as in any way interested, in which case 
he may by agreement become a ''dormant" or "sleeping" 
partner. Again, he may desire to limit his own liability to the 
amount which he invests, in which case he may become a 
"limited" partner. 

There are certain forms of partnerships which are used 
for special or temporary purposes, such as the "syndicate," 
the "joint adventure," etc., but these are details that involve 
us in many technical questions and lead us outside the scope 
of this volume. In all these various forms, however, the 
personal relationship of the owner of the capital to the man- 
agement of the business is a strong element. It may be hidden 
or modified in part, but it is never absent. 

Because of the personal element involved, the partnership 
is regarded as the proper form in which to organize such 
professional activities as those of lawyers, accountants, and 
engineers. In all these cases it may be necessary to bring to- 
gether in one organization considerable capital and the talents 
of many different men. The product of this organization, 
however, is not some material thing, but a direct personal 
service ; hence, .the personal liability and personal relationship, 
which are characteristic of the partnership form, are desirable 
and should be retained. There are other lines of business in 
which it is desired to avoid the legal regulation which is ap- 
plied to corporations, and for this reason the partnership form 
is preferred. This is particularly true of the banking business. 
Most concerns engaged in buying and selling securities, in 
underwriting, and the like, are not incorporated, but are or- 
ganized as partnerships. There are a few large trading and 
manufacturing enterprises in the partnership form. Until 
recently, Arbuckle Brothers and the Baldwin Locomotive 



!6 FINANCE AND BUSINESS ORGANIZATION 

Works were still conducted as partnerships, and this is even 
yet true of Rogers, Peet and Company, of New York. 

Disadvantages of the Partnership 

Of the three disadvantages applicable to the individual 
proprietorship, only one does not apply to the partnership. 
There is very little difficulty under the partnership form in 
attracting high-priced business talent. On the contrary, in 
this one respect the partnership is probably superior to both 
the other basic forms of enterprise. The other two disad- 
vantages of individual proprietorship — the limitation on com- 
mand of capital and the personal liability for all business 
obligations — are, however, shared by the partnership. 

By reason of the personal character of the relationship 
between each of the owners and the business, it is highly un- 
desirable that anyone should be included in a partnership un- 
less he is personally acceptable and able. As all of the part- 
ners, except dormant or limited partners, have equal rights 
in the control of the business, and as any one of them may 
bind the entire firm by his acts or contracts, the consequences 
of bringing in an incompetent partner may easily be very 
serious. As compared with a corporation, this introduces a 
serious handicap in searching for fresh capital with which to 
develop the business. It is necessary not merely to find one 
man with capital and another man with brains to help manage 
it, but to find one man who has both the capital and the brains, 
who is at the same time willing to devote time, money, and 
thought to the enterprise, and whose personality is such as 
to insure harmonious relations with the existing partners. 

The other disadvantage, namely, the personal liability of 
each part owner, is even more serious in the partnership than 
in the sole proprietorship. In the case of the individual pro- 
prietor, he can suffer only through his own misfortunes or 
errors; the partner, however, may suddenly find himself face 



FORMS OF BUSINESS ENTERPRISES ij 

to face with heavy loss due to the bad fortune or errors of any 
of his partners. His own personal property (except under 
one of the special forms of agreement above referred to) 
belongs to the business and to the creditors of the business 
until the last debt has been paid. If one of his partners proves 
dishonest or treacherous, he may be called upon to foot the 
bill — and not merely to the extent of his previous investment 
in the business, but to the extent of all of his personal holdings. 
It is for this reason that a partnership agreement is so weighty 
a matter. Moreover, on the death or withdrawal of any of 
the partners, if an agreement cannot be reached with the retir- 
ing partner or with the estate, it may be necessary to go 
through all the trouble of suit in equity for an accounting and 
wind up the business. 

In the face of these disadvantages it is not surprising that 
very few business concerns, outside the special classes men- 
tioned, have retained the partnership form. It is becoming 
every year relatively of less and less consequence. 

The Corporation 

The corporation is quite distinct from the sole proprietor- 
ship and the partnership. The capital is supplied by a small 
or large group of people called shareholders, or stockholders. 
The business is usually managed by a group of officers and 
directors elected by the shareholders. The shareholders have 
no liability for the debts of the corporation beyond the amount 
which they have contributed as capital. Owing to the possi- 
bility of dividing the capital up into shares of comparatively 
small amount, funds may be raised from the general public 
by putting these shares on the market ; and it is much easier 
to finance a business of great magnitude in this way than 
through either individual ownership or through a partnership, 
in which there are necessarily only a limited number of people. 

The business is thus managed by only a part of the people 



x g FINANCE AND BUSINESS ORGANIZATION 

who supply the capital. The corporation itself is regarded as 
a distinct and separate entity, capable of doing business by 
itself; the corporation may sue, may be sued by, and may ' 
contract with its own members, as well as with outsiders. The 
officers and directors conduct these operations in the corporate 
name. 

The corporate form is used for social and governmental, 
as well as for business, organizations. Towns, villages, and 
cities are conducted as corporations. Corporations for govern- 
mental purposes are called public corporations; corporations 
for business and social purposes, private corporations. 

Religious, educational, charitable, and social organizations 
are usually incorporated without capital stock and are known 
as membership corporations. When corporate action is taken, 
each member has one vote and no more. Mutual insurance 
companies and stock exchanges are among the more important 
of the non-stock corporations. 

All corporations to conduct business for profit have a 
capital stock divided into shares, usually of like amount, which 
are evidenced by transferable certificates of stock. The 
holders of these certificates are termed stockholders. Each 
share of stock usually entitles its owner to one vote in stock- 
holders' meetings, and a majority of the shares elect the 
directors and control the policy of the company. When profits 
are to be divided, they are distributed among the stockholders 
in proportion to the number of shares they own. 

Limited Partnerships 

In an effort to overcome the disadvantages incident to the 
partnership relation, many enterprises, especially in Great 
Britain and the British colonies, have been organized as "joint- 
stock" companies, which may be briefly defined as a form of 
limited partnership. In the United States, as we shall see, 
this movement, though of some importance, has not gone 



FORMS OF BUSINESS ENTERPRISES 19 

very far because of the superior advantages of the corporate 
form. 

A limited partnership may only be formed under special 
laws. It differs from an ordinary partnership in that one 
or more of its partners are silent or inactive; they share in 
the profits but take no part in the management of the business. 
The liability of these partners is limited to the amount actually 
invested by them in the business. These partners whose 
liability is limited are called special partners in contradistinc- 
tion to the other general partners. To secure this restricted 
liability it is necessary to comply closely with the statutory 
provisions. The procedure necessary to form a limited part- 
nership is almost as formal as the incorporation of a stock 
company, and failure to observe the required formalities may 
result in making the special partners liable as general partners. 
Sometimes it is attempted to secure the benefits of this limited 
liability without complying with the state law. In such case, 
the individual who invests his money keeps the matter secret 
and is known as a dormant or "sleeping" partner. If the 
arrangement is discovered, he would be liable in exactly the 
same way and to the same extent as an active partner. 

Joint-Stock Companies 

A joint-stock company is a partnership with its capital 
divided into transferable shares. Except in the State of New 
York, such a company may be formed simply by agreement. 
In New York special statutes provide for an organization 
similar to a corporation, and the formation of such associa- 
tions is prohibited except as provided by the statutes. The 
courts in New York define these organizations as being part- 
nerships with some of the powers of a corporation. In New 
York these joint-stock companies may sue or be sued in the 
name of the president or treasurer, and the individual mem- 
bers mav not be sued until it is shown that the claim cannot 



20 FINANCE AND BUSINESS ORGANIZATION 

be collected from the company. Several of the leading express 
companies are organized under the New York Joint-Stock 
Company Law, and in these cases the arrangement seems to 
work very satisfactorily. In other states the joint-stock com- 
pany form is very rarely used for the following reasons : 

1. Members of the company are individually liable for 

its entire obligations. 

2. While the company can do business under its company 

name, it cannot hold real estate and it is necessary 
that any real property be held by some agent or 
officer as trustee for the company. 

3. The joint-stock company must bring suit in the names 

of all the members, and, if it is sued, only those 
members who are served with process can be held. 

There are cases where the danger of partnership liability 
is too remote to trouble the members, and in such cases the 
joint-stock company secures the same advantage of stock and 
transferable stock certificates as does the corporation. The 
form could not be used where stock is to be sold to investors 
as these would not risk the partnership liability involved. 
Practically, the joint-stock organization is rarely used in this 
country. In Great Britain and the British colonies, it is quite 
common. From a financial standpoint the British joint-stock 
company is practically the same as the American corporation. 
The words "company" or "corporation" will hereafter be used 
interchangeably and refer to either. 

Associations Under Deeds of Trust 

Various experiments have been tried at different times in 
the way of carrying on business through trustees. It was 
long ago decided in England that the actual owners of the 
property could not be held liable as partners if the property 
was in trust and the business carried on by trustees. 



FORMS OF BUSINESS ENTERPRISES 21 

The Standard Oil Company, the Sugar Trust, and the 
Bay State Gas Company in this country were all organized 
as trusts. A board of trustees took over the stock of the 
constituent companies and issued trust certificates to the 
owners. Thereafter, until the courts declared such organiza- 
tions illegal, these boards of trustees dominated their respec- 
tive industries. The courts decided that trusts of this nature 
were illegal, not because of any objection to their form of 
organization, but because their chief object was to restrict 
competition. 

When the trust form was forbidden to these monopolies, 
they resorted to the holding corporation, but the name "trust" 
persisted and is still used to designate the great monopolistic 
corporations. It is misleading and has caused considerable 
unjust prejudice on the part of the public against this method 
of doing business. 

The trust form of business association is used to a limited 
extent in Massachusetts. Up to 19 12 the law in that state 
made no provision for corporations to deal in real estate, and 
consequently a large number of real estate trusts under the 
name of "voluntary associations" came into existence. They 
have increased until they now own not less than $250,000,000 
in real property. Of late years this form of organization has 
extended to a limited degree into other lines of business 
activity and may become a popular form. 

The characteristic features of these voluntary associations 
are as follows: 

1. A deed or declaration of trust, drawn up to define the 

rights and powers of the trustees and the share- 
holders. 

2. Two or more trustees who are authorized to take 

over and manage the capital, business, or property 
supplied by the shareholders. 



22 FINANCE AND BUSINESS ORGANIZATION 

3. Shareholders who receive transferable certificates 

representing their respective interests in the profits 
and in the property on dissolution. 

4. Provisions for division of profits, appointment of 

trustees to fill vacancies, and for dissolution at 
termination of the trust. 

It is usual to provide in the deed of trust that no liability 
is to attach to the shareholders or trustees. 

The Commissioner of Corporations of Massachusetts in 
closing his report summarizes the advantages afforded by 
these voluntary associations as follows:* 

1. The experience of twenty-five years shows that they furnish 

a convenient, safe, and unobjectionable form of co-opera- 
tion, ownership, and management. 

2. Their form of management is more flexible, more economi- 

cal, and more convenient than that of a corporation. Trus- 
tees can do business with more ease and rapidity than a 
board of directors. 

3. In particular they afford a convenient form for combining 

capital for the development and improvement of real 
estate, as the form of organization insures a continuity 
of management and control that specially appeals to inves- 
tors in real estate, and which cannot be secured by a 
corporation on account of the change of officers each 
year. Trustees are not changed as frequently as are 
directors of a corporation. 

Business Organization Under the Latin Law 

The principal forms of business associations in France 
are: (1) the ordinary partnership with a firm name (societe 
en nom collectif) ; (2) the limited partnership {societe en 
commandite) ; (3) the joint-stock company (societe anonyme) . 

The partnership is much the same as under English and 



*Report of Massachusetts Tax Commissioners upon Voluntary Associations, 
January 17, 1912. See also Sears on "Effective Substitutes for Incorporation," and 
Chanler on "Express Trusts." 



FORMS OF BUSINESS ENTERPRISES 23 

American law except that the personal element is even more 
strongly accentuated ; for instance, it would be fraud to insert 
in the name of the firm the proper names of any persons not 
actually connected with the firm. The partners are considered 
to have given each other the right to manage one for the 
other, and to bind the firm by their signatures. 

The so-called socictc anonymc resembles the English joint- 
stock company more closely than the American corporation. 
The separate existence of the association, apart from the 
individuals who make it up, is not so much insisted upon 
as in this country. The directors must be chosen from among 
the shareholders. In France the directors must draw up a 
brief statement every half-year showing the condition of the 
company as regards assets and liabilities. In all corporations 
it is necessary to deduct not less than 5% from the net profits 
of each year for the purpose of forming a reserve fund. This 
deduction need not be continued after the reserve fund has 
come to exceed 10% of the capital of the company. 

In general, without attempting to enter into legal techni- 
calities, the customary character of business associations is 
the same throughout the Latin countries, including France, 
Spain, Portugal, Italy, Belgium, and practically all of South 
America. In all these countries the societe anonyme is the 
form of association which corresponds to our corporation or 
joint-stock company. 

Business Organization Under the German Law 

There are various forms of associations under German 
law of which the stock company {Aktiengesellschaft), and the 
limited liability company (Gesellschaft mit beschrdnkter Haf- 
tung, usually abbreviated m.b.H.) are the two most popular 
forms. 

The stock company may be regarded as, for most practical 
purposes, equivalent to a corporation or joint-stock company 



24 



FINANCE AND BUSINESS ORGANIZATION 



under English and American law. It usually has both a board 
of directors (Vorstand) and a board of managers (Auf- 
sichtsrat), but does not necessarily possess a president, secre- 
tary, and treasurer. Executive power, in other words, is 
lodged in the board and not in individual officers. 

The German limited liability company has been described as 
a cross between an American corporation and a partnership. 
"In contemplation of German law, it is an artificial person 
or juristische Person, and has an existence of its own separate 
and distinct from that of its founders and shareholders; and 
is therefore a body corporate. This corporate form is much 
simpler than the Aktiengesellschaft or stock company. Its 
capital is not divided into shares and no certificates of stock 
are issued. Individual interests or holdings in the company 
may be transferred in whole or in part by notarial or judiciary 
act.* 

This form of association is used chiefly for small com- 
panies in which only a few persons are interested. The man- 
agement is usually determined by agreement among the 
various persons interested, much as in an ordinary partner- 
ship, though in the larger companies of this type there may 
be a board of control. 



*Report on the Commercial Laws of England, Scotland, Germany, and France, 
by Archibald J. Wolfe in collaboration with Edwin M. Borchard, issued by the Bureau 
of Foreign and Domestic Commerce, Washington, D. C, 1915. Much of the informa- 
tion contained in the preceding section also is abstracted from this report. 



CHAPTER III 

THE CORPORATION 

Origin of Corporations 

The modern corporation did not suddenly spring into being 
as a device for overcoming the obstacles of previous forms 
of business enterprises. It has been slowly and painfully 
developing for centuries, and in its present form is a com- 
posite of the ideas and the experience of many different races 
and generations of men. 

On one side, the business corporation is closely related 
to the municipal and religious corporation. The jurists of the 
early middle ages conceived — or rather adapted from Roman 
law — the idea of the church as a legal entity, distinct from 
any of its officers or ministers. It was clear that the endow- 
ments, for instance, which were given to bishops and abbots 
were not intended for their personal enjoyment nor to be 
disposed of as they saw fit. It was desirable that the funds 
should be entrusted to an owner that would exist year after 
year and generation after generation, irrespective of human 
frailties or vicissitudes. Out of this need for permanence 
and for impersonality in holding religious property, grew the 
perfected idea of the church itself and of other religious and 
charitable organizations existing as separate entities or "cor- 
porations." It was an easy step, when a similar need arose 
in business undertakings, to transfer this conception from re- 
ligious organizations to business organizations. 

During the last three centuries, the corporation has grown, 
both in Europe and in the United States, along parallel lines 
of development. The result attained is not exactly the same, 
for there are many technical points of difference between the 

25 



26 FINANCE AND BUSINESS ORGANIZATION 

German Gesellschaft mit beschrdnkter Haftung, the French 
societe anonyme, the English "joint-stock company" and the 
American "corporation/' but these points of difference are 
of no great importance compared with the central fact that 
in all these, and in all other commercial countries as well, there 
has come to exist a certain type of business association, the 
essential features of which are: 

i. Little or no direct personal relation among proprietors 
or between the proprietors and the business; such 
relations as do exist are on the impersonal basis 
of capital invested. 

2. Control and management by elected representatives 

acting in trust for the proprietors. 

3. Liability of proprietors limited to their investment or 

to some fixed amount proportioned to their invest- 
ment. 

Fiction of Corporate Entity 

Both the Continental courts and the English courts have 
tended always to regard the corporation or company as if it 
were a group of individuals, while in this country the tendency 
has been to follow strictly Chief Justice Marshall's famous 
definition in the Dartmouth College case in 18 19, wherein he 
spoke of the corporation as "an artificial being, invisible, in- 
tangible, and existing only in contemplation of the law." The 
logical simplicity of this view appeals strongly to the legal 
mind, and many beautiful bits of fine-spun reasoning based 
upon it are to be found in the records of our courts. But 
unfortunately, it happens to be far removed from the facts of 
every-day business life. We all know that in practice the 
corporation has no existence and no interests apart from the 
existence and interests of its shareholders, creditors, and of- 
ficers. In an ideal world, possibly, men would devote them- 



THE CORPORATION 



V 



selves to building up a business corporation for its own sake, 
just as many men have devoted themselves to building up 
religious and governmental corporations, and in that case there 
would be some solid basis for the lawyer's line of reasoning. 
However, in our work-a-day world, the reverse is more often 
true ; the corporation may easily prove a convenient shield for 
the men back of it who are intent upon actions and policies 
for which they would not care to accept, as individuals, the 
full responsibility. 

The fiction of corporate entity favors this species of mis- 
use. It erects an obstacle — an ''invisible, intangible," but ef- 
fective obstacle — between the wrongdoer and his victim. 

Recognizing this abuse, the courts of this country have 
become more and more inclined in recent years to tear aside 
the corporate mask and look for the men and the motives 
behind corporate actions. This is true at least of courts of 
equity. Nevertheless, we are still tangled and blocked at every 
step by the thousands of precedents consisting of decisions 
based upon the fundamental idea of the corporation as a thing 
distinct from the men who compose it. 

Grant of Powers by the State 

The powers of a corporation are derived from the charter 
granted it by the state and these powers are limited by the 
law in some respects. A corporation has no power to do any- 
thing not expressly mentioned in its charter or necessary to 
carry out some purpose which is expressly mentioned by its 
charter. 

Before the general incorporation acts were passed, the 
corporation had to secure its life and its grant of powers by 
special application and special act of the legislative or sovereign 
authority. Since then, the application has become a matter 
of form only. There is no discretion in the executive 
authority to refuse any request for a charter which conforms 



2 8 FINANCE AND BUSINESS ORGANIZATION 

to a few set forms and regulations. Any citizen has as much 
right as any other to organize a corporation without asking 
a favor from any man or any governmental body. 

Special Charters 

Special charters are still sometimes applied for and ob- 
tained, but they are not in high favor for several reasons. 
First, of all, it frequently requires political influence and pres- 
sure to secure them; second, unless there are some marked 
peculiarities of the law, there is ordinarily no reason to prefer 
a special charter over the ordinary charter obtained under a 
general enabling act; third, a special charter is always more 
or less an uncertain thing because it has not been given 
authoritative interpretation by the courts, whereas the charter 
obtained under a general act can be framed with an eye to 
previous decisions and can thus be cleared of unexpected legal 
pitfalls. 

A feature of public utility corporations in Great Britain 
is the fact that each company is organized and governed by 
a special act. These acts, however, are to a considerable 
extent standardized through uniform clauses and model forms 
that have been adopted by the Board of Trade. In general, 
any company in Great Britain which exercises rights of emi- 
nent domain or other exceptional rights is likely to ask for a 
special charter. However, numerous small gas and water 
companies and other public utilities are operated without 
special parliamentary authority, and are chartered under the 
general enabling law known as the "Companies Consolidation 
Act" of 1908. 

An ordinary charter in the United States is in the form 
of an application to the Secretary of State or other proper 
authority for permission to incorporate ; as soon as a govern- 
mental official has received, approved, and filed this applica- 
tion, it becomes the charter — we might call it the constitution 



THE CORPORATION 



29 



►f the corporation. The information which it contains is 
usually the following: 

1. The name of the corporation. 

2. The purposes for which it is formed. 

3. The amount and classes of corporate stock. 

4. The location of the principal business office. 

5. The period of existence of the corporation which is 

usually unlimited or perpetual. 

6. The names and addresses of the incorporators. 

The Corporate Name 

It is provided in several states that the corporate name 
must include the word "Company" or must be followed by 
some such word as "Incorporated" or "Limited," the purpose 
being to show in the title itself that the enterprise is incor- 
porated. It is in most states forbidden to take a name which 
has been already utilized by some previously existing corpora- 
tion, or to take a name which is so close as to be misleading. 
Corporations which have acquired a great deal of good-will 
value in connection with their names, depend, however, chiefly 
upon the common or statutory laws against unfair competition 
to protect them against imitation or misuse of their names. 

The Corporate Purposes 

The purpose for which a corporation is formed should be 
fully and clearly stated; it is customary to add one or two 
paragraphs of a general nature which give the corporation 
power "to do any and all other acts and things and to exercise 
any and all other powers which a copartnership or natural 
person could do and exercise and which now or hereafter may 
be authorized by law." It is not always convenient, although 
there are usually no legal difficulties, to amend the statement 
of purposes in a charter; for this reason liberality and fulness 
in stating them in the first place are desirable. A great many 



3o FINANCE AND BUSINESS ORGANIZATION 

useful forms for stating the purposes of corporations engaged 
in various lines of business are easily available through the 
standard legal manuals. 

Classes of Stock 

The statement as to the amount and nature of the various 
classes of stock is a section of the charter which is customarily 
amended from time to time in case changes in the company's 
capitalization are made. Sometimes the original statement 
is intended simply as a ''blind." For instance, the certificate 
of incorporation of the United States Steel Corporation 
which was filed in the office of the Secretary of State of New 
Jersey on February 23, 1901, showed a capitalization of 
$3,000. On April 1, 1901 the certificate was amended and 
the capitalization was changed to $1,100,000,000 — one-half 
common and one-half preferred. 

The Principal Business Office 

The principal business office is not necessarily the office at 
which most of the business of the corporation is transacted, 
but is the office at which legal papers may be served and 
certain legal business transacted. Many of the large corpora- 
tions of the United States having their headquarters in New 
York, are incorporated in New Jersey, Delaware, or some 
other state. In that case their "principal business office" is 
likely to consist of a meeting place loaned to them from time 
to time in the office of some firm of lawyers or some trust 
company; the name of the company is usually posted some- 
where so that no one may fail to find the company or its 
representative if he so desires. At the entrance to the office 
of the Corporation Trust Company in Jersey City, there is a 
directory of several hundred corporations all of which have 
their "principal business office" with the Corporation Trust 
Company. _. 



THE CORPORATION ?,I 

It would not be advisable to enter here into other details 
as to the provisions of the charter and the methods of incor- 
porating. The reader who desires more detailed information 
can easily obtain it by consulting the statutes of his own state 
or by referring his inquiries to a capable lawyer. 

Operation in Other Jurisdictions 

After a corporation has obtained a charter, it must still 
face the question of ascertaining its rights and powers outside 
of its home state if it desires to do an interstate or an inter- 
national business. Strictly speaking, a charter does not in 
itself create an existence that can be recognized outside the 
state or nation which gives the charter. The "domicile" of 
the corporation, as the lawyers explain it, must be within its 
home jurisdiction. In the famous case of the Bank of Augusta 
v. Earle, decided in 1839, the United States Supreme Court 
said, speaking of incorporation: "It exists only in the con- 
templation of the law and by virtue of the law, and where 
that law ceases to operate and is no longer obligatory, the 
company can have no existence." If this theory w r ere always 
literally and fully applied, it would be necessary to create a 
new corporation for every state in which an enterprise is 
being conducted. To avoid so unworkable a conclusion, Chief 
Justice Story brought into play the doctrine of interstate and 
international comity. "The laws of one state," he said, "have 
no binding force, it is true, in any other state but they should 
be recognized and so far as possible applied as a matter of 
courtesy." The comments of the English barrister, E. Hilton 
Young, on the doctrines of corporate entity and of interstate 
comity in American jurisprudence, are amusing and well 
founded. "No sooner is it admitted," he says, "that juristic 
persons have no existence except in the contemplation of the 
law which created them, than a fiction is invented to enable 
them to claim a universal existence, A fictitious disability is 



32 



FINANCE AND BUSINESS ORGANIZATION 



overcome by a fictitious recognition, and thus one fiction 
cancels out the other." 

Operation in Foreign Countries 

The tendency of modern thought and practice is toward 
giving recognition in all civilized countries to commercial 
associations formed under the laws of other countries. In 
England the "Companies Consolidation Act" of 1908 requires 
certain formalities of foreign companies which carry on busi- 
ness in the United Kingdom ; by complying with these formali- 
ties, any such company may open a branch office and operate 
on equal terms with English companies. Conventions have 
been made by England with France, Belgium, Italy, Germany, 
Spain, Greece, Tunis, Austria, and Russia for reciprocal ad- 
mission of commercial associations to civil rights. Since early 
in the sixteenth century, it has been agreed that "a foreign 
corporation can appear in its corporate character before the 
English courts and be regarded as a person by the laws of 
England." 

In nearly all the Latin countries, not only of Europe but 
also of South America, it is easy for a foreign corporation to 
obtain rights equivalent to those of a domestic corporation by 
the same simple process of registration. Among European 
countries, Russia and Austria are reported to be most hostile 
toward foreign corporations, while Italy and England assume 
an especially liberal attitude. 

A fair illustration of international practice is the current 
law of Argentina with regard to foreign corporations, which 
is as follows: 

Article I. — Corporations organized under the laws of 
foreign countries may do business in the nation without 
previously acquiring the authority of the government 
providing they give proof before competent magistrates 
of having been constituted in accordance with the law of 



THE CORPORATION 33 

their respective countries and register the statutes and 
other documents appertaining thereto with the Public 
Registrar of trade. 

Article II. — The provisions of the preceding article 
shall from the promulgation of this act be in force for 
the corporations whose country of origin admits reci- 
procity. 

One question that arises in connection with all foreign cor- 
porations is: When may it be said to be "doing business" 
within a given jurisdiction? The customary rule is to the 
effect that isolated transactions may be carried on by any cor- 
poration without its having been previously registered and 
licensed, just as by any natural person. But in case a foreign 
corporation is conducting a regular business and especially if 
it is maintaining a branch office, then it must be registered in 
order to make its contracts enforcible. There is, of course, 
no fixity about this rule, and it is often a delicate question to 
tell whether a corporation is actually doing business within a 
given jurisdiction or not. 

Internal Regulations and By-Laws 

A corporation, having obtained its charter or fundamental 
constitution from the state, is expected to draw up and enforce 
its own internal regulations. It usually at once adopts written 
by-laws as its internal code. Thousands upon thousands of 
corporations, having adopted excellent by-laws, thereafter dis- 
regard them as completely as if they had never existed. The 
larger concerns, however, in connection with which more 
formality is necessary, and the smaller concerns in which there 
is current or probable friction among the members of the 
board, quickly discover that the by-laws are intended to be 
observed carefully and that by so doing much useless trouble 
may be averted. 

The statutes of the State of California give a statement of 



34 



FINANCE AND BUSINESS ORGANIZATION 



the subjects which should be covered in the by-laws of a cor- 
poration, as follows : 

1. The time, place, and manner of calling and conducting 

meetings. 

2. The number of stockholders constituting a quorum. 

3. Mode of voting by proxy. 

4. The qualifications and duties of directors, and also the 

time and method of their annual election. 

5. The qualifications and duties of officers. 

6. The manner of election and tenure of office of all 

officers other than the directors. 

7. Suitable penalties for violation of the by-laws. 

Among the other subjects which are not essential, but are 
frequently treated, are: 

8. Electing directors to fill vacancies up to the next suc- 

ceeding meeting of the stockholders. 

9. Order of business at directors' meetings. 

10. Compensation of directors and officers. 

11. Organization of standing committees of the board of 

directors. 

Rights and Duties of Shareholders 

The men who took part in the early English joint-stock 
enterprises — such as trading expeditions to the Indies or 
Americas — were appropriately known as "adventurers." The 
title would not be inappropriate in many cases if it were ap- 
plied to present-day shareholders in corporations. The average 
shareholder in a large corporation has the privilege of paying 
out money in return for which he receives his holdings of 
stock, and has the right to his proportionate share of whatever 
profits are distributed. He has also the right — which the 
small shareholder seldom exercises — of voting for directors 
who are supposed to represent him. That duty having once 



THE CORPORATION 



35 



been performed, he ceases to be a factor of much importance 
in the management of the company; in fact, as a shareholder, 
he probably does nothing except hopefully wait for and grate- 
fully receive whatever dividends the board of directors sees 
fit to allot to him. 

The American Practice 

In American practice the average shareholder, even of 
smaller corporations, unless he happens to be also a director 
or other officer, is not only helpless, but uninformed. He may 
be furnished, if it so pleases the directors, with a fairly com- 
plete annual report; the more enlightened corporations even 
send out monthly or quarterly statements of earnings. He 
does not, however, meet his directors and officers face to face 
unless as a purely personal or exceptional event. He does 
not ask questions; he has no representative to dig up informa- 
tion for him; he is completely in the dark as to the plans 
formulated by the directors and even as to the real results 
and prospects of his corporation. There are, of course, some 
exceptional cases. A few stockholders occasionally drift into 
the annual meetings of large corporations, but these meetings 
are of so formal a character that the stockholders who attend 
are not likely to be men of much weight and influence. Partly 
because of these conditions, many able business men decline to 
invest in any corporation in which they cannot protect their 
interests by a controlling voice or at least a seat in the direc- 
torate. 

In other countries, the tendency of the management to 
ignore the stockholders has not yet gone so far. Corporations 
in these countries are not of such enormous size as those in 
America. The custom of meeting the directors and officers at 
least once a year and of persistently seeking information as 
to the internal affairs of the company has not fallen so com- 
pletely into disuse. 



36 FINANCE AND BUSINESS ORGANIZATION 

The English Practice 

The English statutes provide for the auditing- of each 
company's accounts by an independent accountant elected by 
the shareholders. The auditor is responsible to the share- 
holders and not to the directors, and he is legally liable to 
reimburse the company for any loss which he might have 
prevented. The courts have said that it is the duty of an 
auditor not to confine himself to verifying the arithmetical 
accuracy of the balance sheet, but to inquire into its substantial 
accuracy. The report of the auditor must be sent to the 
shareholders. The courts have further said that an auditor 
does not discharge his duty by simply putting the shareholders 
in the way of obtaining information; he must state his con- 
clusions in unmistakable terms. 

The absence of any corresponding machinery in the United 
States places the shareholder in a peculiarly helpless situation, 
especially when he suspects impropriety on the part of his 
directors. On July 2, 19 14, W. Bourke Cockran, an eminent 
New York attorney, representing a stockholder of the Inter- 
national Steam Pump Company, appeared before the Supreme 
Court of the State of New York in an effort to compel the 
directors of the company to furnish more complete data than 
his client had previously been able to secure. "Doesn't the 
existing law on corporations give you sufficient power to go 
in and inspect the books?" asked Justice Weeks. "Why, your 
Honor," replied Mr. Cockran, "they would only laugh at any 
one who really tried to get at the books. It would take until 
doomsday. " 

Under recent decisions the New York courts have made 
it possible for shareholders to inspect the stock ledger and 
transfer books of their corporations for the purpose of pro- 
curing a list of the stockholders. This right has, beyond 
question, been abused by various individuals who have made 
copies of lists of shareholders for the mere purpose of using 



THE CORPORATION 



37 



them as mailing lists for advertising purposes. These lists of 
shareholders of important corporations have even been ad- 
vertised for sale. Nevertheless, in spite of this abuse, the 
right must be maintained and enforced; otherwise a share- 
holder of a large corporation, even though he might have 
important information that would affect the votes of his 
fellow shareholders, would have no economical and effective 
way of communicating with them. 

On the basis of what has just been said as to the rights 
of shareholders, it is evident that large discretionary powers 
must be left to the directors. No matter what improvements 
might be made in the relations of the shareholders to their 
corporation, they could not themselves undertake the direct 
management of its affairs. In very small or close corporations 
it is possible that the individual shareholder may have some 
personal influence which could be made of value to the cor- 
poration, but in large corporations the individual can accom- 
plish little except through his vote or through membership 
on the board of directors. The Pennsylvania Railroad Com- 
pany has over 93,000 shareholders, of whom 45,000, or nearly 
one-half, are women ; the women shareholders own over 28% 
of the outstanding stock. The American Telephone and 
Telegraph Company has 62,000 shareholders and the United 
States Steel Corporation has 110,000. 

Rights and Duties of Directors 

The board of directors has the final legislative and judicial 
authority within a corporation. The board elects officers, 
determines policies, authorizes contracts, passes on methods of 
financing, declares or withholds dividends, and in general 
manages all the affairs of the corporation. This describes 
their legal status and responsibilities. 

In practice, however, boards of directors are likely to 
become mere appendages or echoes of some one or two in- 



38 . FINANCE AND BUSINESS ORGANIZATION 

dividuals who actually direct the corporation. The real, final 
authority is frequently lodged in the president, if he is an 
active man and performs all the duties of his office, and the 
board of directors simply ratifies his decisions. This is fre- 
quently the case even though the directorates may be made 
up of able and forceful men. Under the American system 
they have no direct interest, except as shareholders, in the 
profits of the corporation, and cannot afford to devote a great 
deal of time and thought to its activities. They have con- 
fidence, presumably, in the president or in the chief officer 
or officers, whoever they may be, and they prefer for their 
own convenience and comfort to leave the whole corporation 
in the care of its actual head. The thing that frequently hap- 
pens, therefore, is that the shareholders elect directors; the 
directors elect a president or other chief officer ; and this man 
designates the other officers, fixes the policy of the concern, 
and carries on all its affairs subject only to the formal ratifica- 
tion of his board. So long as the president and other officials 
are well chosen, the system works well. Its weakness lies in 
the fact that the directors themselves are poorly informed and 
are left in a helpless or ignorant condition as compared with 
the officers ; hence they are quite unable to protect themselves 
or the corporation against practices on the part of the officers 
that are perhaps detrimental. In place of a representative 
democracy, which is the ideal form of government for a cor- 
poration, they substitute a small tyranny. 

This common state of affairs is due, in the United States, 
partly to the custom of choosing directors of important cor- 
porations from a very small circle of well-known business 
men. The result is that one man may serve on 10, 20, 50, or 
even 75 different boards. Even though some of these boards 
may be those of subsidiary corporations which transact noth- 
ing but the most formal business, nevertheless the men who 
are members of so many boards cannot be thoroughly in- 



THE CORPORATION 39 

formed as to any of them. Within the last two or three years, 
there has been a significant tendency to reduce the number of 
directorates of which one man is a member, but the number 
is still too large. William H. Newman, for instance, Chair- 
man of the Board of the New York Central Railroad Com- 
pany, who was at one time a director in 112 separate corpora- 
tions, is now a director in 73 companies. H. L. Doherty, who 
is largely interested in public utility properties, is a director in 
66 corporations. W. K. Vanderbilt, Jr., is a director in 65 
corporations. E. T. Stotesbury is a director in 58 corpora- 
tions. In England there was at one time a custom of filling 
directorates with gentlemen of title, most of whom were in- 
credibly ignorant of all business transactions. More recently, 
according to Hartley Withers, it is becoming more the fashion 
to put in men who are supposed to know something about 
the business, "but the real requirement, that of genuine busi- 
ness capacity, is still to a large extent left out and probably 
must be as long as directors' fees are on their present ab- 
surdly small scale." 

Corporate Officers and Directors 

At the other extreme is the small corporation which makes 
all its officers directors and allows its directors to make them- 
selves officers. It is, of course, quite proper and customary 
that some of the leading officials should be included in the 
directorate, but a directorate that is made up wholly of officers 
is obviously a body in which there is great danger of "log 
rolling." An officer who is also a director cannot easily afford 
to oppose fellow officers and directors who have complete 
power over him. If there are no outside directors who are 
not involved in the internal affairs of the corporation to whom 
he may appeal, an honest, zealous officer is peculiarly in a 
position of disadvantage. The custom of having all or nearly 
all of the directors chosen from the officers of the corporation 



a FINANCE AND BUSINESS ORGANIZATION 

may work well for temporary periods just as any other un- 
sound arrangement may work for a time. It is, however, 
fundamentally incorrect and has many times proved a fruitful 
source of friction and inefficiency. 

The "Clayton Bill" 

The so-called "Clayton Bill" of October 15, 1914, now 
makes unlawful in the United States the practice of serving 
on the directorates of two or more banks, either of which 
has deposits, surplus, and undivided profits aggregating more 
than $5,000,000. The Act further provides that no citizen 
shall be a director in two or more competitive corporations 
engaged in whole or in part in commerce, any one of which 
has capital, surplus, and undivided profits aggregating more 
than $1,000,000. The purpose of this measure was to inter- 
pose obstacles in the way of improper restraint of trade. Its 
effectiveness in accomplishing this purpose is open to question. 
As a method of discouraging business men from attempting 
to serve on too many directorates and of opening up more 
opportunities to other men of perhaps equal ability but of 
narrower reputation, however, it will be beneficial so far as 
it goes. 

"Ornamental Directors" 

The report of the Interstate Commerce Commission in 
1914 on the financial history and status of the New York, 
New Haven and Hartford Railroad, strongly condemns in- 
activity and ignorance on the part of the directors. "There 
are too many ornamental directors," to quote the plain 
language of the Commission, "who have such childlike faith 
in the man at the head, that they are ready to endorse or 

approve anything he may do The minutes of the New 

Haven's meetings reveal that the Board confined itself almost 
whollv to ratifying and authorizing action; there was little 



THE CORPORATION 



41 



real information or discussion. None of the directors would 

have been so careless in the handling of his own money as 
the evidence demonstrated they were in dealing with the 
money of other people." 

On the other hand, there is sometimes a mistaken idea 
that the board of directors ought to manage all the details 
of a business. Its real function is selecting the right officials, 
outlining policies, and passing well-informed judgment from 
time to time as to the efficiency and honesty of the manage- 
ment. One of the most successful publishers in the United 
States, Colonel Henry Watterson of Louisville, recently gave 
his opinion on the witness stand of directorates which run 
too much to details. Referring to the management of the 
New York World after the death of the organizer and former 
proprietor, Joseph Pulitzer, Colonel Watterson said: "I un- 
derstand that the paper is edited by a Board of Directors. 
You might as well try to run a locomotive by a Board of 
Directors. The moment the wisdom of one man or two men 
is superseded by the folly of one man or two men, the efforts 
of a lifetime may then and there be wrecked. It has been 
done repeatedly." 

Compensation of Directors 

It has been suggested that one reason for the inefficiency 
and the light ethical standards of the directorates of some 
important corporations, is to be found not only in wrong 
practice in selecting these men, but also in wrong practice in 
compensating them. In many foreign countries, notably in 
continental Europe, it is the custom to distribute among the 
directors at the end of each year, a fixed percentage of the 
net profits; thus each director, even though he may not be a 
heavy shareholder, has a direct and personal interest in build- 
ing up the profits. He is less likely to wink at incompetence 
or to avoid criticism that would be for the good of the cor- 



4 2 



FINANCE AND BUSINESS ORGANIZATION 



poration, if he realizes that he must himself pay a portion 
of the penalty in the form of reduced compensation. Paul 
Warburg, formerly of the firm of Kuhn, Loeb and Company, 
has expressed his belief that in this country we should follow 
the European plan of paying directors in proportion to the 
dividends they can earn. One important gain in this plan 
is that it becomes easier to secure as directors men who may 
themselves have only a small shareholding interest in the 
corporation; the range of choice is widened. As matters 
stand now, a man wishes to be a director of an important 
corporation for either one of two reasons: because he has a 
large share-interest that he feels he should protect, or because 
it adds to his prestige. This second motive has a strong 
influence in making up the directorates of banking institutions. 
"Membership on the boards of good banks," someone has 
said, "is largely a social function." This is not the way to 
get efficient, hard-working directors. Under our system it 
is common practice to pay nominal fees for attendance at 
board meetings, but they seldom amount to more than $20 a 
meeting, and, therefore, these fees are not a factor of any real 
weight. 

This question of compensation as well as some other ques- 
tions that are touched upon in this section, will come up for 
fuller discussion when we consider the subject of exploitation 
of corporations. (See Chapters XXIII, XXIV.) 

Legal Status of Directors 

As to the legal status and responsibilities of a director, it 
seems to be well settled that a director is a quasi-trustee on 
behalf of the body of shareholders. He is certainly not en- 
titled, either legally or morally, to use his position primarily 
for his personal profit at the expense of the other shareholders. 
While there is no question that this is frequently done, and 
as we shall see later on is often defended, it is permitted in 



THE CORPORATION 



43 



many companies to continue only because the shareholders 
cannot offer legal proof of their suspicions. 

A director ordinarily is not liable to the stockholders for 
acts of his co-directors unless he participates in the action or 
acquiesces by not making a vigorous protest. Just what is 
meant by 'vigorous protest" is difficult to say. Where the 
wrong is serious, the directors ought to apply to the courts. 
In New York State there is a provision to the effect that 
directors must file their protest, in writing, or cause it to be 
entered in writing on the minutes. 

Contracts with Directors 

A question that frequently arises, relates to contracts be- 
tween a corporation and a director, or between a corporation 
and another enterprise in which a director is interested. There 
are several views in the various jurisdictions as to the validity 
of such contracts. In New York the law is somewhat un- 
settled, but several decisions have been made to the effect 
that they are voidable but not void, and that they are there- 
fore binding on the corporation at its own option. The 
United States Supreme Court has held that such contracts 
may be voided if lack of good faith is proven, but that they 
are presumptively valid. The United States Steel Corporation 
has an interesting proviso in its by-laws covering this point, 
which reads as follows: 

Inasmuch as the directors of this Company are men 
of large and diversified business interests, and are likely 
to be connected with other corporations with which from 
time to time this Company must have business dealings, 
no contract or other transaction between this Company 
and any other corporation shall be affected by the fact 
that directors of this Company are interested in or are 
directors or officers of such other corporation, if at the 
meeting of the Board or at the Committee of this Com- 



44 FINANCE AND BUSINESS ORGANIZATION 

pany making, authorizing or confirming such contract or 
transaction, there shall be present a quorum of directors 
not so interested; and any director individually may be 
a party to or may be interested in any contract or trans- 
action of this Company provided that such contract or 
transaction shall be approved or be ratified by the affirma- 
tive vote of at least 10 directors not so interested. 



CHAPTER IV 

THE CORPORATE FORM— ADVANTAGES AND 
DISADVANTAGES 



Corporations in Modern Business 

The great commercial agencies of the United States list 
about 1,700,000 individuals, firms, and corporations as being 
in business. About 350,000 corporations in the United States 
made returns under the Corporation Tax Law of the United 
States for the calendar year 19 12. This would seem to in- 
dicate that about one-fifth of all business enterprises are or- 
ganized in the corporate form. However, these figures do 
not in themselves give anything like an adequate idea of the 
relative importance of the corporate form. The 80% of busi- 
ness enterprises owned by individuals or by partnerships in- 
clude, with comparatively few exceptions, only small concerns. 
The 350,000 corporations include nearly all the important en- 
terprises of the country. It is interesting to note the distribu- 
tion of these 350,000 corporations on the basis of their capi- 
talization, which is as follows: 

296,670 corporations with capital of less than $1,000,000 



4,688 


t a a 


$1,000,000 


tO $2,000,000 


1,399 


t it (( 


2,000,000 


" 3,000,000 


677 


i a tt 


' 3,000,000 


" 4,000,000 


292 


t a tt 


' 4,000,000 


" 5,000,000 


861 


t tt ft 


' 5,000,000 


" 10,000,000 


652 


1 tt it 


' 10,000,000 


" 50,000,000 


62 


1 it a 


' 50,000,000 


" 100,000,000 


65 


1 a tt 


' 100,000,000 


and over 



In other countries also, large enterprises are almost always 
organized under the form corresponding to the corporation. In 

45 



4 6 FINANCE AND BUSINESS ORGANIZATION 

the three years 1911-1913, nearly 1,000 joint-stock companies 
were authorized to operate in Russia ; the average capital was 
about $750,000, showing that they were nearly all large en- 
terprises. In Japan, out of 1,445 commercial banks, only 54 
are owned by individuals and the rest by joint-stock companies. 

The Number of Small Corporations 

Yet, the corporation is by no means confined in its useful- 
ness to concerns doing an enormous business. On the con- 
trary, it is becoming every year more and more frequent to 
organize even small enterprises in this form. The "one-man 
corporation" or "the close corporation" is no longer an isolated 
phenomenon. Thousands of men who prefer to have them- 
selves and their estates relieved from possible liabilities due to 
misfortunes of business, or who wish to organize in such a 
way that it will be easy to sell interests or gradually to transfer 
the control, have decided to adopt the corporate form. The 
expense of so doing is slight, and they feel that it is well 
worth while. 

It is becoming more and more common also to incorporate 
the estates of deceased persons and to distribute shares in the 
corporation among the heirs of the estate so that a proper 
division of interest may be secured without a physical division 
or forced sale of the property. Small corporations for tem- 
porary purposes, also, are not uncommon. An individual may 
get up a corporation to publish a book or to carry through a 
piece of speculating in real estate. 

Indeed, the question is often raised whether this tendency 
is not being overdone ; whether many enterprises that would be 
better off as temporary syndicates or as special partnerships, 
are not unthinkingly being made over into corporations. As 
regards many individual cases, the question is no doubt well 
justified. On the whole, however, there can be little question 
but that the corporation has proved itself useful, sound, and 



THE CORPORATE FORM 47 

economical, not only for nation-wide and world-wide con- 
cerns, but for small and local enterprises as well. 

The Army of Stockholders 

Another point to consider here is the great number of 
persons interested in corporations as holders of their stocks 
and bonds. Recently, 195 companies have reported to the 
Wall Street Journal a total of 779,054 stockholders. This 
takes no account of bondholders. There is, of course, a vast 
amount of duplication due to the fact that the lists of these 
195 companies are not checked against each other, and one 
man may be a stockholder in a great many different com- 
panies. Even making this deduction, it is clear that American 
corporations have a great number of stockholders. On a 
smaller scale, the same thing is true in other countries. It 
constitutes one sound reason for saying that the corporate 
form of organizing enterprises is becoming one of the far- 
reaching factors in modern business life. 

Types of Business Corporations 

Some reference has been made in Chapter III to the an- 
cient religious and charitable corporations from which the 
idea of a distinct existence for the corporation, apart from 
the people who organize and manage it, was derived and ap- 
plied to business corporations. In modern times this class 
of religious and charitable corporations has been broadened 
to include all corporations not organized for profit. They are 
often spoken of as "non-stock" corporations. This term now 
includes municipal and other chartered governments and 
societies, as well as religious and charitable corporations. For 
the most part these non-stock corporations are not concerned 
directly with business enterprises, and we need give them no 
further consideration. There are a few exceptional cases of 
corporations chartered in this form for business purposes, 



4 8 FINANCE AND BUSINESS ORGANIZATION 

such as stock and produce exchanges and business associations 
of various types. 

Close and Open Corporations 

In the ordinary business corporation, an important prac- 
tical distinction is to be made between "close" and "open" 
corporations (in England more frequently called "private" 
and "public" corporations). A "close" corporation is one the 
stock of which is held by only a few persons who make very 
few purchases or sales so that there is no public market for 
this stock. An "open" corporation is one the stock of which 
is constantly being bought and sold so that the ownership 
varies from time to time. There is obviously no clear-cut line 
of distinction. Many corporations enjoy only a small and 
local market for their shares, but nevertheless are in part 
"open" in the sense that there would be no difficulty for an 
outsider to purchase a few shares at any time he chose. On 
the other hand, there are many large and highly successful 
corporations the stock of which is in the hands of a few in- 
dividuals who do not care to dispose of it. As will be pointed 
out more fully a little later, the tendency in the United States 
has been to concentrate the attention of the investing and 
speculating public largely on the shares of a few great corpora- 
tions, with the result that other corporations have not had as 
full and free a market for their shares as may be found for 
corporations of the same size and class in other countries. 

A "close" corporation is usually a direct successor to a 
partnership; or, if not, is a small concern. As a business 
enterprise expands and more and more people become in- 
terested, first the partnership is changed to a corporation, and 
later the shares of the corporation begin to be passed from 
hand to hand. Almost insensibly the concern gradually begins 
to emerge from the ranks of "close" corporations and, if it 
keeps on expanding, eventually finds its shares widely dis- 



THE CORPORATE FORM 



49 



tributed and passed from hand to hand. This is the common, 
but not the universal, process. Among the large companies in 
the United States the shares of which are reported to be 
closely held, are the Winchester Repeating Arms Company, 
the Mills and Gibb Company, the Jones and Laughlin Steel 
Company, and the Cerro de Pasco Investment Company. 

Holding Companies 

A striking development of recent years has been the grow- 
ing use and importance of companies which hold the stock 
of other corporations. There was originally no thought that 
corporations might be organized for any other purpose than 
to conduct directly the business operations specified in their 
articles of incorporation. It was in time discovered, however, 
that among the possible powers of a corporation, it might hold 
securities of other corporations just as an individual might 
do. At the beginning, the only use made of this power was 
to purchase interests that could be regarded as useful to the 
corporation or as subserving the main purpose for which it 
was created. This remains today the most common and im- 
portant purpose for which corporations acquire the shares 
of other corporations. 

But the holding company device has proved extremely use- 
ful also for another purpose on which public attention has 
been largely centered. This purpose is to achieve a combina- 
tion of competing concerns which will restrain competition and 
be within the requirements of the law. This subject has been 
so fully discussed in various books and articles that it needs 
only a brief reference. Before the adoption of the "holding" 
company device, combinations of competing concerns had been 
effected in several different ways. The first attempt to achieve 
such combinations in the United States was made by competing 
railroads which worked out various "gentlemen's agreements" 
for the regulation of rates and competitive methods. These 



So 



FINANCE AND BUSINESS ORGANIZATION 



agreements never stood the strain of every-day use for any 
long period. They always broke down because they were not 
hard and fast contracts; they were differently interpreted by 
the various individuals who entered into them and had no 
legal sanction. 

The Illegal Combination 

Another form of combination that has proven unsuccessful 
in this country — though it has worked to some extent abroad 
— is the "pool" or selling agency, which is an agreement to 
restrict production and sales, and which frequently accom- 
plishes this purpose by having all the sales of the competing 
companies handled by one selling organization. This arrange- 
ment was found to be illegal in this country and was given 
up more than a generation ago. 

Its successor was the "trust," using that word in its legal, 
not its popular, sense. Under the "trust" form of combina- 
tion, controlling shares in competing corporations were turned 
over to a group of trustees who issued in exchange their 
trustees' certificates. The trustees were able in this way to 
direct all the corporations and to restrain their competition 
with each other. In the late 8o's this arrangement also was 
found to be illegal and consequently the trusts were dis- 
solved. 

Shortly afterward began the use of the "holding" company 
to accomplish this same purpose. One corporation was formed 
which purchased the controlling shares of competing corpora- 
tions and was thus able to direct them in the same way that 
the trusts had previously done. After many years of agita- 
tion and litigation, this method also has in recent years been 
found to be illegal. Some of the large holding companies have 
been dissolved by order of the courts and others have volun- 
tarily relinquished their holdings of stocks of competing com- 
panies. 



THE CORPORATE FORM ^ 

Legality of Holding Companies 

Out of the discussion and the various legal measures that 
have been taken, there has arisen a popular feeling that all 
holding companies are questionable, and it has even been 
seriously proposed that a corporation should be forbidden to 
hold stock in any other corporation. Yet, as a matter of fact, 
no real legal objection to a holding company itself has ever 
been raised. The only question has been whether the holding 
company has been used for purpose of restraining trade and 
competition, and it is that use which is forbidden. For any 
purpose that is not illegal, a holding company may be used as 
effectively and with as little legal objection as ever. 

Combination of Non-competitive Companies 

There are two other purposes for which one corporation 
may hold the stock of other corporations: one purpose is to 
bring about a grouping or combination of concerns that are 
non-competitive ; the other purpose is to control subsidiary cor- 
porations in such a way as to advance the main interests of 
the holding company, but not with a view to preventing or 
restraining competition. We find the best illustration of the 
first of these two purposes in the public utility field. There 
are about 140 large holding companies which own controlling 
interests in a number of electric light and power, gas, and 
traction corporations. Of approximately $2,112,000,000 of 
securities issued by electric light and power companies, about 
82.5% are owned by these 140 holding companies; of about 
$1,320,000,000 of securities of artificial gas companies, about 
66% are owned by the holding companies ; of $4,043,000,000 
of securities of traction companies, about 81.4% are owned 
by the holding companies. So far as the available records 
show, only one holding company in this class has ever been 
placed in receivership, and that was on account of financing 
large irrigation schemes. 



52 



FINANCE AND BUSINESS ORGANIZATION 



The chief advantages of applying the holding company 
plan to public utilities are : 

1. Most of the local companies are in small cities and 

do not have the resources which would enable them 
to employ high-priced talent. The holding com- 
panies, through their superior resources and or- 
ganization, are able to increase the efficiency of the 
local companies. 

2. While the securities of the local public utilities can 

be sold only in or near the place of their operations, 
the securities of great holding companies enjoy a 
national and even international market and con- 
sequently can be sold more widely and on a much 
better basis. 

There appears to be no reason to condemn the holding 
company in this field. On the contrary, it has been continually 
an aid to economy and efficiency. The London Underground 
Electric Railways is purely a holding company. There are, 
however, comparatively few examples outside the United 
States of this device. 

The Use of Subsidiary Corporations 

The control of subsidiaries may be accomplished through 
the creation of a separate corporation to handle a distinct phase 
of the company's business, or through the purchase of interests 
in companies previously existing, the main corporation being 
in this case the holding company. The use of subsidiary cor- 
porations is becoming more and more extensive. A certain 
manufacturing corporation, for instance, has one operating 
company, one selling company, one purchasing company, one 
company owning a short railroad, one real estate company to 
buy land and erect buildings, and another company to operate 
these buildings. The United Cigar Stores Company ajso has 



THE CORPORATE FORM 53 

a distinct corporation for the handling of its real estate opera- 
tions. 

Advantages of Subsidiary Corporations 

The advantage of forming a distinct corporation rather 
than simply establishing another department of the business, 
is not always clear to the outsider, but may frequently be due 
to personal relations. A first-class real estate man, for ex- 
ample, may not desire to come to a corporation as a paid em- 
ployee, but would be willing to assume the management of a 
distinct corporation under conditions that would enable him 
to secure adequate profit. Again, it is frequently desired to 
give the manager of a plant or of a branch office an oppor- 
tunity to acquire a personal stock interest in the operations 
directly under his control, and this can be most easily done 
through the formation of a separate corporation. Recently, 
a case was brought to the writer's attention of a furniture 
company which has gradually extended its business until it 
now handles various lines not strictly connected with the furni- 
ture business, including papers for wrapping and packing 
furniture. This company found that difficulty was being ex- 
perienced by their sales force in calling upon people interested 
in the paper business because of the impression that the sales- 
man had only furniture for sale. The difficulty was easily 
overcome by forming a separate company to handle the sale 
of paper, with a separate name, stationery, and sales man- 
ager, but otherwise conducted as a part of the parent concern. 

It may be thought strange that a corporation holding a 
charter and grant of powers from the state, could be organized 
so lightly and for so minor a purpose, yet the illustration is 
not unrepresentative. It has become so easy and common a 
thing to organize a corporation for some specific purpose, that 
it is frequently done with very little thought and often when 
little or nothing is gained. Possibly this tendency is going a 



54 



FINANCE AND BUSINESS ORGANIZATION 



little too far, and might properly be curbed by closer super- 
vision on the part of the state and by somewhat higher or- 
ganization and franchise taxes. On the other hand, we should 
not overlook the usefulness of the arrangement in many in- 
stances, and should not be misled by a cry against holding com- 
panies into condemning or preventing practices that on the 
whole make for business efficiency. 

Advantages of Corporate Form 

The underlying advantages of the corporate form for 
most business concerns, have already been indicated in point- 
ing out the disadvantages of the individual proprietorship and 
partnership. They may be listed as follows: 

i. The corporate form makes it possible to distribute 
ownership among any number of persons and 
thereby to raise very large amounts of capital. 

2. The relationship between the owner of a corporate 

security and the business itself being purely imper- 
sonal, the securities which represent ownership may 
be freely transferred. 

These two points make a corporation attractive to in- 
vestors. 

3. The liability of owners of corporate securities is 

limited to their investment — or in certain excep- 
tional cases to a larger amount bearing a fixed pro- 
portion to their investment. 

4. The fact that the ownership and management are 

separated makes it possible to procure a high grade 
of specialized talent for managerial positions, 
whereas in a partnership form the partners them- 
selves usually fill these positions; in many lines of 
business, for instance, railroads and public utilities, 
this is a striking and important advantage. 



THE CORPORATE FORM 



55 



5. The life of the corporation is not dependent upon the 
lives and activities of individuals; the duration of 
the business, therefore, is not so immediately af- 
fected by the misfortunes of individuals. 
One or two examples will indicate how these advantages 
may be utilized in different fields of operation. Some two 
years ago a real estate operator was able to secure control of 
a tract of land of about 600 acres, situated on the outskirts 
of a small city in the Middle West, which proved to have on 
it some valuable beds of gravel and clay. A portion of the 
property also was suitable for cutting up into small residence 
lots. The operator paid about $300,000 for the property. 
He estimated that with proper management it should have a 
value of over $600,000, yet he was himself unable to handle 
it and had found great difficulty in securing a buyer. Under 
these conditions he was advised to form a corporation, issue 
bonds and capital stock which could be sold not only in the 
near-by city, but at various other points, and thus secure for 
the corporation the funds with which to go ahead with the 
development of the property. The plan was finally adopted 
after considerable delay, and at this writing is in process of 
being successfully worked out. In no other way than through 
the organization of a corporation would it have been prac- 
ticable to finance this undertaking. 

Advantage of Partnership Incorporation 

A somewhat similar instance arose in connection with the 
dissolution of a partnership due to disagreement and personal 
friction between the two partners. One partner, who owned 
a one-third interest in the business, had in addition about 
$50,000 and desired to purchase control. The other partner 
was willing to sell. However, the total value of the business 
approximated $300,000, so that it seemed to the minority 
partner impossible to buy the two-thirds interest he wished 



q6 FINANCE AND BUSINESS ORGANIZATION 

with but $50,000. The solution of the difficulty was found in 
organizing a corporation which issued notes, preferred stock, 
and common stock. The majority partner took all of the 
notes and preferred stock and a portion of the common stock 
for his share ; the minority partner took common stock alone 
and received enough to give him control of the new corpora- 
tion. The corporate form, in this case, proved sufficiently 
elastic to enable the two partners to adjust satisfactorily a 
situation which otherwise would have led to costly quarrels 
and litigation. 

Under personal ownership, either by individuals or by 
partnerships, it is difficult if not impossible to make an adjust- 
ment of claims upon the property which will correspond ex- 
actly to the various shades of desire for management, income, 
and risk. The corporate form is peculiarly well fitted for 
dividing and recombining and for issuing various forms of 
securities in such a way as to bring about this desired corre- 
spondence. 

Advantage of Continuity of Ownership 

Again, the great advantage of continuity of ownership of 
a business, even though one or more of the persons jointly 
interested may die or withdraw, is often of paramount im- 
portance. William L. Douglas, it is stated, owns all of the 
common stock of the W. L. Douglas Shoe Company of Brock- 
ton, Mass. An arrangement has been made, however, to 
appoint three trustees who, in the event of Mr. Douglas' death, 
would carry on the business along lines that he has marked 
out. 

Disadvantages of the Corporate Form 

There are certain minor disadvantages of the corporate 
form which may in some cases be of sufficient importance to 
prevent the adoption of this' form. The first and most im- 



THE CORPORATE FORM 



57 



portant is simply the obverse of the advantage of limited 
liability for the shareholders. Sometimes this advantage in- 
volves placing a corresponding limitation on the credit of a 
corporation. Let us suppose the case of a wealthy man who 
desires to back a small trading concern. If he becomes a 
partner in the concern, thus placing behind it his personal 
resources, it may be presumed that the concern will have all 
the credit that it can properly use. On the other hand, if he 
merely takes shares in a corporation, he has no further legal 
obligation in connection with the business, and his action in 
some circumstances may even be regarded as indicating a lack 
of confidence. Undoubtedly the corporate form does lend 
itself to certain kinds of swindling operations. It has been 
too common an occurrence for unscrupulous retailers to form 
a corporation, purchase a stock of goods on credit, dispose 
of the goods, transfer the money to themselves, and let the 
corporation go into bankruptcy. Such happenings tend to 
arouse suspicion, and in some lines of business may lead to 
undue restriction of the credit of small corporations. 

Yet this result is not unavoidable. It is quite possible for 
any shareholder or any group of shareholders who desire to 
do so, to put their personal indorsement on the notes of a 
corporation or to give personal guarantee covering payment of 
the corporation's accounts. In so doing the shareholders would 
place themselves in no worse position than if they were to 
become partners in the business. 

The second disadvantage is governmental control. This 
has already been alluded to in speaking of the reasons why 
many banking and brokerage houses are not incorporated. 
Financial corporations are under specially close supervision 
and limitations on their business. 

Most states require all corporations to subject periodical 
and detailed reports to boards or officials; this causes con- 
siderable trouble and expense, but, as necessitating system in 



58 



FINANCE AND BUSINESS ORGANIZATION 



keeping corporate records, it is sometimes worth all the labor 
it entails. 

The third minor disadvantage is the expense of organizing 
a corporation. This expense is always small in proportion to 
the capitalization. The organization tax, plus the filing and 
incidental fees, of a $100,000 corporation in New Jersey is 
$35 ; in New York $65 ; in Delaware, $25 ; in Maine, $67 ; and 
in South Dakota, $18. The yearly franchise taxes for a cor- 
poration of this size are in New Jersey $100; in New York, 
$150; in Delaware, $10; in Maine, $10; in South Dakota, 
nothing. Other expenses, such as lawyers' fees for drawing 
up the corporation charter, and the like, should not be large. 
The act of incorporation is nothing more than routine legal 
business. 

In Canada, a Dominion or Federal charter is issued upon 
payment of a fee of $250 for a capitalization of $200,000, plus 
50 cents for every $1,000 additional. There are also license 
fees to pay to the government of the province in which the 
company does business, which may amount to $200 to $350 
for a corporation capitalized at $200,000. In all other modern 
countries, the fees and expenses are small unless an attempt 
is made to procure a special charter instead of operating under 
the general Incorporation or Companies' Act ; in that case the 
cost may become very high indeed. 

A fourth disadvantage that may be mentioned is the fact 
that the charter and by-laws of a corporation give a certain 
fixedness to its organization and its powers which may at 
times prove more or less embarrassing. If these documents, 
however, are wisely drawn, it is unlikely that there can be 
any trouble of this nature; if there should be any such trouble, 
it is nearly always a very easy and simple matter to make 
such amendments as are called for. 

The incorporation under state laws also makes it necessary 
to procure certificates allowing the corporation to operate in 



THE CORPORATE FORM 59 

other states from those states, and there is as a usual rule 
some expense attached to that. 

Corporations doing business in more than one state are 
also liable to be taxed by several states on the same property, 
while at the same time their shareholders may also be paying 
taxes on their respective interests in the stock, making a double 
or treble tax on the same property. 

All these disadvantages, it is clear, are for most corpora- 
tions of slight importance. They have evidently not proved 
a serious obstacle to the adoption of the corporate form, for 
this tendency has gone on year by year, increasing in strength 
so that now it is uncommon for enterprises of any size, with 
the few exceptions noted above, to be organized in any other 
form. 

Efficiency of Corporate Organization 

Adam Smith, the first and perhaps the greatest of econo- 
mists, was extremely skeptical as to the usefulness of the large 
"joint-stock" companies which in his day were just beginning 
to play a prominent part in business life. "Without a monop- 
oly," he says, "a 'joint-stock' company, it would appear from 
experience, cannot long carry on any branch of foreign trade, 
for it is a species of warfare in which the operations are con- 
tinually changing, and which can scarcely ever be conducted 
successfully without such an unremitting exertion of vigilance 
and attention as cannot long be expected from the directors of 
a joint-stock company." Elsewhere he asserts that "negligence 
and profusion must always prevail more or less in the affairs 
of a 'joint-stock' company." 

In view of the rapid spread of the joint-stock or corporate 
form of organization and the immense number now in ex- 
istence, it may seem at first glance that wise old Adam Smith 
for once was entirely wrong. Yet, if he were to step into 
twentieth century life and read all the details of the life in- 



60 FINANCE AND BUSINESS ORGANIZATION 

surance scandal, the New Haven Railroad scandal, the Rock 
Island Railroad scandal, and the various other unsavory 
messes that are from time to time brought to light, he would 
perhaps not be easily convinced. 

As a matter of fact, it is probably true that the various 
advantages cited in preceding paragraphs are responsible for 
the wide-spread adoption of the corporation, rather than any 
claim it can reasonably offer to superior efficiency. 

There are some features of corporate organization which 
are no doubt an improvement in respect to efficiency, over 
any other forms of organization. The people who supply the 
money are not necessarily the ones who personally manage 
the enterprise ; and this leaves or should leave an opportunity 
to engage men of special talent as managers. The custom at 
one time was to select one of the largest stockholders as the 
nominal president of an important bank, railroad or manu- 
facturing corporation, but this has now been largely aban- 
doned in favor of making the president the responsible man- 
ager. Often he holds only a few shares of stock. The most 
important or influential stockholder, instead of becoming presi- 
dent, is more frequently made chairman of the board — a posi- 
tion which usually pays no salary. Furthermore, it is at least 
theoretically true that the creation of a board of directors 
representing the owners of the business who can oversee and 
check or stimulate the officers, is a striking gain. On the 
other hand, these advantages have been in large part nullified 
by the selection of incompetent or overoccupied directors. 
As Adam Smith foresaw, these men are not so zealous in pro- 
tecting the shareholders as they are in advancing themselves. 
Sometimes responsibility is so divided that it rests too lightly 
on the shoulders of each individual director. Hartley Withers 
makes the interesting comment that "the real business of most 
boards is done by a small minority who save the rest from the 
consequences of their inexperience. In actual practice the 



THE CORPORATE FORM 6l 

notion that the board is chosen by the shareholders or is really 
representative of the shareholders, is generally a delusion. 
The board either forms itself or is formed by the promotor 
and fills its own vacancies, subject only to the purely formal 
confirmation of the shareholders. The officers are chosen 
by the board or by one another, and joint-stock companies 
are thus governed in practical fact by a self-elected oligarchy." 
This is true not only in London, which Mr. Withers has in 
mind, but in New York, Montreal, Paris, Berlin, and every 
other part of the world. How do these self-chosen oligarchies 
work, and what do they accomplish? 

Insolvency of the Northern Pacific 

During most of the period 1882- 1892, Henry Villard was 
not only a director of the Northern Pacific Railroad Company, 
but was president of the company, and was generally regarded 
as its active and responsible head. Writing in 1905, however, 
in his "Memoirs" and no doubt wishing to excuse himself in 
part for the insolvency of the company under his management, 
Mr. Villard said: 

In 1 89 1 Mr. Villard .... made .... his last official 
tour of inspection of the main line and principal branches 
of the Northern Pacific .... The most alarming im- 
pression of all made upon him was the revelation of the 
weight of the load that had been put upon the company 
by the purchase and construction of the longer branch 
lines in Montana and Washington, which he then dis- 
covered for the first time .... They represented a total 
investment in cash and bonds of not far from $30,000,000, 
which together hardly earned operating expenses. The 
acquisition and building of these disappointing lines had 
in a few years absorbed the large amount of consoli- 
dated bonds set aside for construction purposes, which 
had been assumed to be sufficient for all needs in that 
direction for a long time.* 

*CJuoted in Stuart Daggett's "Railroad Reorganization," pp. 286-287. 



62 FINANCE AND BUSINESS ORGANIZATION 

It is clear that Mr. Villard, whatever may have been his 
abilities and good intentions, was not devoting sufficient atten- 
tion to the business of this corporation to qualify himself to 
direct it. 

Management of the Colorado Fuel and Iron Company 

Some interesting testimony along somewhat the same line 
was given in April, 19 14, by John D. Rockefeller, Jr., who 
was called before a subcommittee of Congress and questioned 
as to his control over the Colorado Fuel and Iron Company. 
Mr. Rockefeller testified that his father held 40% of the com- 
mon and 40% of the preferred shares in this company. He 
stated that he was a member of the board of directors, but 
did not attend meetings, and explained that he had every con- 
fidence in the officers of the company and kept in touch with 
them by correspondence. The chairman of the committee 
intimated that Mr. Rockefeller should have attended an im- 
portant meeting in October. "If you mean that I should have 
gone to Denver to attend a meeting of the board of directors," 
was the reply, "I will say that it is not by attending the board 
meetings that we keep in touch with the officers. If the time 
comes when we cannot rely on the officers then we will get 
somebody else, for it is impossible for us to attend to all of 
these things ourselves, and we have got to get the ablest men 
obtainable to act for us." 

Avoidance of Centralization 

Another criticism frequently levelled against the efficiency 
of large corporate organizations, is based upon the alleged 
inability of the board of directors sitting at the head office 
to grasp and appreciate conditions at the branches. Some- 
times, it is asserted, with regard to the holding companies 
operating in the public service field, that the supervision ex- 
tended to subsidiaries is inadequate, and that headquarters 



THE CORPORATE FORM 63 

lacks personal touch with the local situation of each subsid- 
iary and with the temper of the public that is being served. 
In some cases this criticism has been frankly accepted as in 
part valid, and the remedy has been found by securing as 
directors for local subsidiaries the strongest and best men in 
the local communities. 

Duties of Directors 

On the whole, there seems to be reason for believing that 
corporate organization is tending to increase in efficiency. 
Shareholders and the investing public are becoming more and 
more acquainted with the evils of careless and irresponsible 
direction of their properties. They are gradually becoming 
acquainted, also, with the more common methods of exploita- 
tion and are insisting upon remedies. The only real and per- 
manent remedy for corporate inefficiency lies in the develop- 
ment of higher standards of business morality. Directors 
should be sincerely convinced — as perhaps a majority of di- 
rectors are — that they are in a position of trusteeship which 
they have no right to accept unless they intend to fulfil all its 
duties vigorously and conscientiously, and that next to actual 
dishonesty, the most serious charge that can be made against 
a director is negligence ; in fact carelessness in handling other 
people's money is itself a form of dishonesty. When this truth 
is so widely recognized and so thoroughly driven home that 
it cannot be lightly overlooked, the corporate organization will 
begin to achieve its proper ratio of efficiency. 



Part II— Capital 



CHAPTER V 

OWNED CAPITAL 

Owned and Borrowed Capital 

The capital funds used in business enterprises fall into two 
classes, "owned funds" and "borrowed funds." In an in- 
dividual proprietorship or in a partnership the distinction is 
clear and easily made. The total value of the assets of such 
a business is represented on the liability side of the balance 
sheet, first by obligations, or "borrowed funds," and secondly 
by proprietorship, including whatever surplus has accumulated. 

In a corporation the distinction between "owned" and 
"borrowed" capital is not always so clear, nor is it so vital. 
The corporation itself owns all of its assets and owes not 
only its obligations, but also its capital stock and surplus. The 
creditors and the shareholders of the corporation hold varying 
amounts and degrees of claims against the corporation which 
almost imperceptibly shade into each other. The distinction 
between debenture bonds and certain types of preferred stock 
is slight. Indeed, it would be difficult to name any dividing 
line which clearly separates the shareholders from the obliga- 
tion holders, or creditors, of a corporation. 

Nevertheless, we may in general follow the customary line 
of distinction and say that most bonds, notes, accounts pay- 
able, and other obligations of a corporation, may be regarded 
as representative of borrowed capital, and most shares of 
capital stock may be regarded as representative of owned 
capital. 

6? 



66 CAPITAL 

Some companies have practically nothing but owned 
capital; that is to say, their borrowings are almost nil. Or- 
dinarily, the only corporations in this condition are those 
which have just started, or those which are small and strug- 
gling and have not the credit which would enable them to 
borrow even on short time. Once in a while, however, we 
find a large corporation which follows the same policy. For 
instance, the W. L. Douglas Shoe Company carries on the 
liability side of its balance sheet only common stock, preferred 
stock, and a small amount of current accounts payable. 

A small enterprise is usually conducted on the owned capi- 
tal of the proprietor or the partnership, with possibly recourse 
to the bank for short-term loans from time to time. Also, 
the proprietor or one of the partners will sometimes borrow 
money for the business on his personal note, secured perhaps 
by mortgage of his real estate, and thus increase his invest- 
ment and the amount of the partnership's owned capital by 
the amount so secured. 

When there is a single proprietor, he may perhaps, when 
additional capital is required, secure this by the admission 
of a partner with capital. A partnership might accomplish the 
same result by adding another partner. It is possible at times 
for firms to secure additional capital by admitting special or 
limited partners, who take no active part in the business but 
who invest capital and share in the profits. In many states 
the statutes provide that the special or limited partner shall 
not be liable to creditors of the firm beyond his investment. 

When the statutes do not provide for limited partnerships, 
the same end may be accomplished by admitting a dormant, 
silent, or sleeping partner. The dormant partner takes no part 
in the business, and usually avoids publicity as to his connec- 
tion with the business. If known to be a partner, he may be 
held for the partnership obligations, like any other member 
of the firm. 



OWNED CAPITAL 67 

It is, of course, always possible for a sole proprietorship 
or partnership to incorporate and issue stock; if it does so, 
its capital problems are then the same as those of any other 
corporation. Many small businesses have been incorporated, 
and most businesses when they increase to a certain point 
incorporate, on account of the facility given by the corporate 
forms in securing additional capital. 

Stocks and Shares 

The title of this section is borrowed from an exceptionally 
readable book by Hartley Withers, to which reference is made 
below. At first glance the combination of words in the title 
seems to the American reader so much nonsense, for in the 
United States we are accustomed to apply the two words 
"stocks" and "shares" almost indiscriminately, both meaning 
the units of a corporation's owned capital. We derive our 
meaning of the word "stock" in its financial sense from its 
original meaning of something heaped up like a stack; this 
is the sense in which it is used in the phrase "stock in trade." 
Adam Smith uses the word to mean the capital of a firm or 
company, and this meaning has survived in the United States, 
but not in Europe. In England, stock is distinguished from 
shares by the fact that it is divisible into, and transferable in, 
odd and varying amounts, ranging from tens of thousands 
down to a penny. At the original subscription anyone may 
take any odd amount of the stock that he cares for. The 
Stock Exchange calls the amount that is not divisible by one 
hundred, a "broken lot." Stock is quoted on the London 
Stock Exchange at so much per £100. Shares are distinguished 
from stock by the fact that they are expressed in terms of 
definite amounts and are indivisible. There are, however, 
some few English companies that will transfer fractions of 
shares.* 



'Hartley Withers' "Stocks and Shares," pp. 33-38. 



68 CAPITAL 

In the United States there is no security which corresponds 
to what the English call stock. The owned capital of any 
corporation is always represented by an issue of shares, each 
share being of a uniform amount with the other shares in 
the same series, and of like standing and rights. In both 
countries the capital stock of the corporation may be of two 
or more classes, which in this country are usually called "com- 
mon" and "preferred." In England the more usual titles are 
"ordinary" and "preference," and in that country there is a 
much larger variety of shares than we have here. There are 
"deferred" shares, "founders' " shares, "deferred ordinary" 
shares, "preferred ordinary" shares, and so on almost indef- 
initely. In this country, after we have used the terms "com- 
mon" and "preferred" we usually fall back on such matter- 
of-fact titles as "first preferred," "second preferred," "third 
preferred," and the like. 

Transfer of Stock 

Shares of stock are ordinarily represented by certificates 
issued by the corporation, each one of which states on its face 
how many shares it represents, to whom it is issued, and the 
legal conditions, if any, under which the shares are issued. 
These certificates are transferable and negotiable when in- 
dorsed in blank by the person to whom they were originally 
issued. They may pass from hand to hand, be used as col- 
lateral for bank loans, and be transferred many times, before 
being finally sent in to the corporation for transfer — -that is, 
in order that the name of the new owner of the certificate 
may be entered as a stockholder and a new certificate may 
be sent to him. This transfer on the books of the corporation 
is usually attended to before the transfer books are closed in 
anticipation of a dividend. Inasmuch as dividends are paid to 
stockholders of record as they are registered in the books of 
the corporation, it is desirable that the n^w owner of a cer- 



OWNED CAPITAL 



6 9 



tificate- should be careful to see that his name is entered 
promptly. 

The larger corporations entrust the issuing, handling, and 
checking of their certificates: of stock to a registrar and a 
transfer agent, both of which usually are trust companies. It 
is the business of the transfer agent to see to it that the record 
of stockholders is kept up to date, and that old certificates are 
cancelled and new ones issued as called for. It is the business 
of the registrar to check the issuance and see to it that no more 
are put out than have been authorized and issued for property. 
This practice of having a registrar to check the transfer agent, 
is an outgrowth of the era of wild speculation on the New 
York Stock Exchange in the seventies and eighties, when the 
leaders were Jay Gould, James Fisk, and Daniel Drew. In 
their operations these men were not trammeled by any legal or 
moral restraints. If it suited them to set the printing presses 
going and secretly to put out large new issues of unauthorized 
securities, they did so, and were able, apparently, to keep 
within the bounds of the law. To guard against activities 
such as these and to make their stocks more readily salable, 
the older and more conservative corporations started the prac- 
tice of engaging independent registrars. 

A Corporation Dealing in Its Own Stock 

A question which often arises is whether or not a cor- 
poration may acquire or deal in its own stock. Courts in 
New York, California, Wisconsin, and other jurisdictions 
have decided in recent years that, in the absence of statute 
to the contrary, a corporation may deal in its own stock, pro- 
vided the purchase or sale is made in good faith and without 
injury to creditors. However, the statutes of many states 
pecifically forbid this practice. It is obviously objectionable 
when it is so used as to bring about a reduction in outstanding 
capital stock without due process of law, or when it is used 



~ CAPITAL 

as a method of paying off certain favored shareholders at the 
expense both of the other shareholders of the company and 
of the creditors. 

"Common Stock" or "Ordinary Shares" 

In the United States we speak of "common stock"; in 
England they use the term, "ordinary shares." The two ex- 
pressions are practically identical in meaning; both refer to 
shares which have no special privileges or rights but which are 
entitled to whatever capital or income remains after prior 
claims have been satisfied. One verbal exception to this gen- 
eral statement may be noted. In English usage there are 
sometimes "deferred" or "deferred ordinary" shares, which 
are inferior in claims to the so-called ordinary shares. In 
this case the shares that are called ordinary are really "pre- 
ferred." Once in a while the same practice is found in the 
United States. For instance, the Denver Reservoir Irrigation 
Company has three classes of common stock, which are known 
respectively as "A," "B," and "C" common. Voting power 
is vested only in classes "A" and "B," which accordingly are 
given preference in this respect over the "C" class. Cus- 
tomarily, however, common, or ordinary, shares are all of the 
same class and represent the final equity in the enterprise after 
prior claims have been made. 

The simplest case of capitalization arises when a corpora- 
tion has outstanding only one class of stock, and no notes or 
bonds. The laws of several states specifically provide that 
in the absence of any special preference for certain classes of 
stock, all stock shall be of one class and shall be known as 
common stock. It is well to keep this rule in mind and to 
realize that any stock which is set aside and given certain 
privileges or rights is entitled to nothing more than is specifi- 
cally assigned to it. We shall see that there is no rule, or 
even established custom, as to the rights and privileges of 



OWNED CAPITAL j\ 

so-called preferred stock. The common stock is entitled to 
every privilege that is not specifically taken away from it. 

Preferred Shares 

Although preferred shares are entitled only to what is 
specifically granted to them, some customs have become fairly 
well established. In the United States nearly all industrial 
preferred shares bear cumulative dividends at the rates of 6%, 
7%, and 8%, a great majority receiving 7%. Just why these 
percentages should have been chosen is somewhat difficult to 
say. Probably the best answer is to be found in the statement 
that high-grade preferred shares have been selling for several 
years on about a y% basis; that is to say, if they are 6% 
shares they sell at about $86 for each $ioo shares; if they 
are J% shares they sell at about par; and if they are 8% 
shares they sell at about $114 for each $100 share. Inasmuch 
as shares, when they have a market value of or near par, are 
more convenient and more salable than would otherwise be 
the case, there is an advantage in making their preferential 
dividend 7%. There is, however, nothing fixed in this custom. 
If the general level of prices changes so that good industrial 
preferred shares begin to sell at par on a 6% basis, we may 
expect to see the customary rate changed to 6%. 

The preferred dividend may be either "cumulative" or 
"non-cumulative." A cumulative dividend is one which carries 
over from year to year; that is to say, in case the profits are 
not sufficient to pay the full preferred rate in any given year, 
the unpaid dividends will remain as a prior claim to be paid 
in some succeeding year before dividends are declared on 
the common shares. Non-cumulative dividends give the pre- 
ferred shares a prior claim for dividends each year; but in 
case these profits are not sufficient to meet the claims, or for 
other reasons dividends are not declared, no obligation rests 
upon the corporation to make up the deficiency in later years. 



1* 



CAPITAL 



At one time most preferred shares were non-cumulative. 
But as such they have been found unsatisfactory because of 
the conflict of interest between the common and the preferred 
shareholders as to the payment of preferred dividends each 
year. It is obviously to the advantage of the common share- 
holders to defer dividends on the preferred shares as long as 
possible, since the cumulating profits inure directly to the 
benefit of the common stock. It is a simple matter of account- 
ing procedure to use whatever profits accrue to the corpora- 
tion to increase assets and to pass preferred dividends, until 
sufficient profits have accumulated to pay equal dividends to 
both preferred and common stock. There is plenty of op- 
portunity not merely for unfair diversion of funds away from 
the preferred shareholders, but also for the expression of 
differences of opinion as to whether dividends are honestly 
withheld. 

Non-cumulative preferred stock, is as stated, undesirable. 
It is, in fact, a standing invitation to the directors, unless their 
ethical standards are high, to administer the corporate finances 
to the advantage of the common stockholder. Profits that 
might very properly have been applied to the preferred div- 
idends are diverted into improvements or developments. 
These redound to the ultimate advantage of the company, but 
meanwhile stand in the way of dividends on the non-cumula- 
tive preferred stock until the company has reached a point 
where common and preferred stock dividends are both pos- 
sible. The preferred stockholder's dividends for this period 
are absolutely lost as far as he is concerned. The company 
has profited at his expense. The directors might properly 
have paid them if they would, but decided in favor of the 
common stockholder. 

If investors were wise there would be no sale for the non- 
cumulative stock, for there is no legal way for the holder 
of such stock to prevent the directors postponing dividends 



OWNED CAPITAL 



73 



until the common stockholders can share equally or even re- 
ceive more than do the holders of preferred stock. 

It is to be noted that if the preferential dividend is to be 
non-cumulative, this fact must be clearly expressed in the 
charter provisions by which the stock is authorized. Where 
not so expressed the courts have held the preferential dividends 
to be cumulative and payable in full out of the first profits 
before anything is received by the common stock. The cumu- 
lative feature of preferred stock is, however, for the sake of 
security and definiteness usually covered by express provision. 

On the other hand, cumulative dividends have an uncom- 
fortable habit of piling up, and may become in the course of 
a few years so serious a burden as to leave no reasonable hope 
for dividends on the common shares. Such a situation might 
interfere with, or prevent entirely, additional financing were 
it needed. It is not at all uncommon in corporate experience 
for a company to go through several years of depression and 
limited income, and then, through good management or by 
some fortunate circumstance, suddenly enter upon a period 
of prosperity. Naturally, the common shareholders, having 
received no dividends through the 'lean" years, feel that they 
are entitled to some recompense. If a large amount of un- 
paid dividends on cumulative preferred shares stands in the 
way, it is now customary to try to find some way, under the 
conditions stated, of " funding" these unpaid dividends, thus 
satisfying both the common and the preferred shareholders. 
The "funding" of the unpaid dividends is accomplished by 
issuing securities of some kind to the preferred shareholders 
in exchange for their dividend claims. 

Shares may be preferred not only as to dividends, but also 
as to assets; that is, in case of dissolution or insolvency, the 
full par value of the preferred shares is to be paid before 
any payment is made on account of the common shares. We 
shall see, when we come to consider reorganization, that as 



74 



CAPITAL 



a matter of fact going corporations are seldom sold or entirely 
liquidated and the assets distributed among the various security 
holders. It is usual to bring about a reorganization in which 
the claims of each class of securities are so readjusted that 
they may all be met by the corporation. Hence the prior 
claim of preferred shares upon assets is not to be taken too 
literally, but is to be regarded rather as a legal point of ad- 
vantage in securing the best possible terms in case reorganiza- 
tion should become necessary. From this point of view, the 
preference as to assets is of considerable importance. 

It is well to reiterate that the preferences granted to pre- 
ferred shares are no more than are distinctly specified, and 
that these preferences may consist not only of prior claims 
as to dividends and assets, but of prior claims as to voting. 
For instance, the preferred shares of the Rock Island Com- 
pany of New Jersey (the former holding company for the Chi- 
cago, Rock Island and Pacific Railway) were entitled to elect 
a majority of the directors of that company. It is more 
usual, however, for preferred shares to have no vote, on the 
theory that the responsibility for conducting the corporation 
should rest with the non-preferred shares, which take the 
greater part of the risk. 

In every case in which preferred shares are under con- 
sideration, it is necessary to go to the charter or by-laws and 
find out exactly the nature of the preference. In 1901 there 
was a struggle between the Hill-Morgan party on the one 
side and the Harriman-Kuhn, Loeb party on the other, for 
control of the Northern Pacific Railroad Company, in the 
course of which the Hill-Morgan party secured a majority of 
the common shares, and the Harriman-Kuhn, Loeb party a 
majority of the preferred shares together with enough of the 
common shares to give them a majority of the entire outstand- 
ing stock. Inasmuch as both common and preferred shares 
had voting rights, it seemed clear that the victory remained 



OWNED CAPITAL 



75 



with the Harriman-Kuhn, Loeb group. Unfortunately for 
their calculations, however, the charter of the company gave 
the common shareholders a right at any time to redeem the 
preferred shares at par. This right the Hill-Morgan party 
exercised and, through the control thus given them by a clause 
which had apparently been overlooked by their opponents, 
obtained the upper hand. 

Origin and Uses of Preferred Shares 

Preferred shares came into popularity in the United States 
chiefly on account of their influence in railroad reorganizations. 
It was, and is still, customary in severe reorganizations to cut 
down the fixed obligations of the corporation by compelling 
some of the junior bondholders to accept preferred shares in- 
stead of their bonds. By making this exchange, the former 
bondholders retain their claims upon the income of the cor- 
poration, but the claim is made simply a preference instead 
of a positive obligation. Except in reorganizations, preferred 
shares have been very little used in the United States by rail- 
road corporations. 

An entirely different use has been found for them, how- 
ever, in connection with large industrial corporations. It has 
become customary to represent the tangible assets and the 
current earning power of corporations by bonds and preferred 
shares, and to represent the intangible assets and expected 
income by common shares. Nearly all of the large industrial 
corporations formed in the last twenty years have followed 
this policy. One of the striking features of the stock market 
during the last five years has been the successful floating of a 
large number of preferred share issues by the smaller indus- 
trial corporations. Sometimes these shares are sound, some- 
times unsound. In either case it seems to be fairly easy to 
dispose of them; the buying public has evidently been edu- 
cated to like and approve industrial preferred shares. 



76 CAPITAL 

Preferred shares are sometimes used also to distribute vot- 
ing power in such a way as to give control to a comparatively 
small group. The Rock Island preferred shares, referred to 
above, were of this kind. 

In the smaller corporate organizations, preferred stocks 
are often used to make the adjustments necessary in the in- 
corporation of partnerships. If it is desired to give equality 
of voting right, the partner having an excess of capital is given 
a similar excess of stock in non-voting preferred stock. Or, 
common stock may be given to those who have the manage- 
ment, and preferred stock may be given to those who are to 
retire from the business. By means of the two kinds of stock, 
almost any desired difference of investment or power of con- 
trol may be secured. 

Protection of Preferred Shares 

It has already been noted that in modern corporations the 
distinction between owned capital and borrowed capital is 
sometimes shadowy. Preferred shares, for instance, are some- 
times protected and subject to redemption in such a way as to 
bring them almost, if not wholly, into the same class as junior 
bonds. It is very common practice for a company to reserve 
the right to redeem preferred shares, usually at a premium 
varying from 5% to 20% or more. The decision of the 
matter, however, rests with the corporation. Further than this, 
many companies make redemption obligatory and even provide 
for the building up of sinking funds for this purpose, just 
as in the case of sinking fund bonds. The California Petro- 
leum Corporation, for example, sets aside five cents on each 
barrel of petroleum sold, to redeem its preferred shares. The 
May Department Stores, the Studebaker Company, and the 
Underwood Typewriter Company all have sinking funds for 
this purpose. The provision in the charter of the Underwood 
Typewriter Company reads as follows: 



OWNED CAPITAL yy 

There shall be set apart from the net profits of the 
Company at the rate of not less than $100,000 per annum, 
a fund to be known as "Special Surplus Capital Reserve 
Account," which shall be made and kept going at the rate 
of $100,000 per annum for each year before any divi- 
dend shall be paid on the common stock, and after the ex- 
piration of three years from the date of incorporation of 
the Company said Special Surplus Capital Reserve Account 
shall be used annually in the purchase and retirement of 
said preferred stock at the lowest price at which the 
same may be obtainable, but in no event exceeding a pre- 
mium of 25% over and above the par value thereof. Such 
purchases may be made at the option of the Company 
either at a public or private sale, and all preferred stock 
so acquired shall be cancelled. 



It is also becoming a more and more prevalent custom to 
protect preferred stock by specific provisions as to percentages 
of current liabilities to current assets, of net surplus to capital, 
of dividends to current surplus, and the like. The Canadian 
Inter-Lake Line is required by its charter to establish a cumu- 
lative reserve fund equal to 50% of the outstanding preferred 
stock, and to maintain the fund by setting aside out of earn- 
ings an amount equal to at least 3% par value on the outstand- 
ing preferred stock. In the case of the Moline Plow Com- 
pany, the net quick assets must always equal at least $140 
per share of first preferred. Montgomery, Ward and Com- 
pany provide that no additional preferred beyond the present 
issue can be put out unless, after such issue, the net quick 
assets shall equal at least 120% of the outstanding preferred. 
The Griffin Wheel Company has a number of detailed provi- 
sions. Additional issues (after the original issue) of its pre- 
ferred stock cannot be put out up to more than 66 2/3% of 
the cost of improvements, extensions, or increased working 
capital. Common dividends may not be increased to more 
than y% unless the net tangible assets are at least 50% of the 



yg CAPITAL 

preferred shares; even then, the common may get only one- 
half the surplus earnings above the preferred and previous 
common dividends. When the tangible assets rise to 200%, 
the net quick assets being 50% of the preferred, the directors 
of this company may declare such dividends on the common 
"as may be deemed prudent.' , 

A form of protection given by many companies is the 
proviso that the preferred shareholders shall automatically ob- 
tain control, or partial control, over the directorate of the cor- 
poration in case their claims are not met. It is customary to 
give the preferred the power to veto an increase of bonds or 
of preferred stock. The Wisconsin Central Railroad Com- 
pany provides that in case of failure for two successive years 
to pay 4% dividends on its preferred, the preferred share- 
holders shall have the right to elect a majority of the directors. 
In the American Smelters Securities Company, the preferred 
shareholders are permitted to vote if dividends for one year 
remain unpaid. The William Carter Company gives both the 
preferred and the common shares equal voting power, except 
that if there is default in four successive quarterly dividends 
on the preferred, or if the net quick assets for one year remain 
at less than the par value of the preferred shares outstanding, 
the preferred becomes the sole voting stock. The American 
Sumatra Tobacco Company provides that if unpaid dividends 
accumulate above 14%, the preferred shareholders shall have 
the right to elect a majority of the board. The International 
Motor Company provides that if the preferred stock fails to 
receive dividends, it shall obtain the sole voting power. The 
American Rolling Mill Company gives its 6% preferred stock 
the right to vote only when three successive dividend periods 
have been passed. 

All of these provisions appear to be equitable, although 
the mere grant of voting power to preferred shareholders, if 
the common shares still retain control of a corporation, may 



OWNED CAPITAL 



79 



prove to be a concession of only slight importance. If it is 
expected and seriously intended that the dividends on pre- 
ferred shares shall be paid regularly year after year, then it 
would seem only fair that the common shareholders, if they 
should fail to live up to this expectation, should forfeit control 
and give the preferred shareholders a chance to see what they 
can accomplish. It may be objected that an arrangement of 
this kind would involve the possibility of shifting the control 
from one set of shareholders to another from year to year, a 
practice which would be fatal to the interests of both classes. 
The answer to this objection is to be found in the fact that 
whatever minor conflicts of interest may exist between the pre- 
ferred and the common shareholders, both are likely to do all 
they can to build up the corporation, and this tendency would 
probably not prove serious. It may be further suggested that 
preferred shareholders, after all, bear a considerable part of 
the risk in most corporations, and ought from the beginning 
to have at least a small share in the management; they could 
be given complete control in the event of default in the pay- 
ment of preferred dividends. 

In Canada it is unusual to deprive preference shareholders 
of their customary right to vote upon their shares. The Com- 
panies Act of the Dominion states that: 

Holders of shares of preference stock shall in all 
respects possess the rights, and be subject to the liabili- 
ties, of shareholders within the meaning of this Act, 
provided that in respect of dividends and in any other 
respect declared in by-laws as authorized by this Act, 
they shall, as against the ordinary shareholder, be entitled 
to preferences and rights given by such by-laws. 

It is plainly implied here that preferred shareholders are en- 
titled, unless there is some clear agreement to the contrary, 
to vote on an equalitv with common shareholders. 



80 CAPITAL 

Dividend Rights of Preferred Shares 

Unless otherwise expressly provided, preferred stock par- 
ticipates equally with the common stock in all dividends after 
both common and preferred have received an equal dividend. 
That is, if the preferred stock has received its preferential 
dividend of, say, 6% together with any cumulated arrearages, 
it participates no further in dividends until 6% has been paid 
upon the common stock as well, but thereafter both classes of 
stock stand upon exactly the same basis as to any further 
dividends declared during that year. If such further partici- 
pation on the part of the preferred stock is not desired, it 
must be expressly denied. Ordinarily the charter contains a 
provision prohibiting such participation, in which case the 
preferred shares receive their fixed dividends, but no more. 
Yet there are numerous exceptions to this general rule. For 
instance, the American Brake Shoe and Foundry Com- 
pany pays 7% on preferred shares, and follows that with 
7% on common shares; the preferred shares are then entitled 
to all additional earnings. The Chicago, Milwaukee and St. 
Paul Railroad Company's preferred has a prior claim to 7% 
and, after the common has received 7%, shares equally with 
the common in any further distribution. The Chicago and 
Northwestern Railway's preferred is entitled to 7%, to be 
followed by 7% on the common, and then the preferred is 
entitled to an additional 3% before the common draws any- 
thing more. At present the preferred stock of this company 
is receiving 8%, and the common 7%. 

Allis-Chalmers Company preferred draws 7%, then the 
common 7%, then the preferred is entitled to 1% extra but 
has no further claim. James Stewart and Company has out- 
standing $1,500,000 7% cumulative second preferred, which 
participates equally with the common in further distributions 
after the common has received 10%. Harrison and Crossfield, 
Ltd., a large English house dealing in foreign and colonial 



OWNED CAPITAL 8l 

produce — tea, rubber and the like — has outstanding a pre- 
ferred ordinary issue of £300,000 drawing a cumulative div- 
idend of 5%. After an equal amount has been paid on the 
management shares, the balance of the profits are divided 
equally until the preferred ordinary have received a further 
5% ; the remaining surplus is the property of the manage- 
ment shares. The preferred ordinary shares have received 
their full 10% dividend each year since the formation of the 
company. Aberthaw and Bristol Channel Portland Cement 
Company, an English concern, has a preferred issue which 
is entitled to 10%, and which, after io r /c has been paid 
on the common, receives two-thirds of the remaining 
profits. 

Redemption of Preferred Shares 

There are a number of provisions concerning the redemp- 
tion of preferred shares, that are worth noting. The General 
Asphalt Company has outstanding $14,000,000 5% cumula- 
tive preferred which is convertible into common at any time 
on even terms, in addition to which the preferred shareholder 
will, in this case, receive also $50 of common that is held in a 
trust fund. Thus $100 of preferred stock can be converted 
into $150 of common at any time. The American Oriental 
Company has outstanding $2,000,000 7% participating pre- 
ferred which is convertible into common, share for share. As 
to the rate of redemption, the Fisk Rubber Company has an 
unusual provision to the effect that in case of forced liquida- 
tion the preferred stock is entitled to par and accrued divi- 
dends, but in case of voluntary liquidation it is entitled to 120% 
of par and accrued dividends. A few English companies base 
the redemption of their shares of preferred on the market 
value. Thus Apollinaris and Johannis, Ltd., provide that 
in the event of voluntary liquidation all preference stock shall 
be entitled to a sum equal to the average price at which the 



§2 CAPITAL 

stock has been sold in two preceding years, but not less than 
par. R. and J. Dick, an English concern which does an ex- 
tensive business in the United States in boots, shoes and belt- 
ings, provides that in the event of dissolution the preferred 
shares shall have a prior claim up to their par value, plus a 
sum equal to the average premium at which the shares may 
have been quoted at Glasgow during the three years preceding- 
dissolution. 

General Characteristics of Preferred Shares 

From the various examples that have just been cited, the 
reader may construct a composite picture of preferred share 
issues. He will find that they range in their fixed dividend 
rate from as low as 4% to as high as 10%, ■ with a marked 
preference among industrials for j c fo. He will find that a 
great majority either are irredeemable or are redeemable at 
the option of the corporation, and that a small number are 
protected by sinking funds and by other provisions which 
make them, for all practical purposes, obligations of the cor- 
poration. 

In the United States comparatively few preference shares 
are given voting power. In England, and more especially in 
Canada, the custom is just the reverse.. It is, however, becom- 
ing more and more common in this country to give preferred 
shares some contingent voting power so that they may assume 
control, or at any rate exercise some influence, in case of de- 
fault of payment of their regular dividends. There are many 
preferred shares that have some claim on dividends above 
their fixed rate ; these are known as ''participating preferred" 
shares. Special provisions regarding convertibility and re- 
demption are found here and there. In general, it should be 
noted that shares may be preferred in a great many different 
respects and forms, and that it is therefore necessary to study 
each instance of preference separately. 



OWNED CAPITAL 83 

Special Forms of Shares 

There are many peculiar varieties of capital shares which 
do not come definitely within the two main classes, common 
and preferred, or which have notable features. In Great 
Britain it is a common practice to compensate the organizer 
of a corporation by giving him a final claim on earnings which 
is valid only after all the claims of those who have furnished 
capital have been fully met. The shares which represent this 
claim are variously known as "founders' " shares, "manage- 
ment" shares, and "deferred" shares. Although this practice 
is frequently condemned, it seems at least as defensible as the 
custom in the United States in accordance with which the 
promoter of a corporation retains by way of compensation, as 
much as he can of the common stock. Deferred, management, 
or founders' shares in England are usually of very small par 
value — most commonly, one shilling per share. In case the 
corporation succeeds in fulfilling the expectations of its or- 
ganizer, the founders' shares may come to receive large div- 
idends and to possess a high market value altogether out of 
proportion to their nominal value. Indeed, there are instances 
in which separate companies have been formed in order to hold 
the founders' shares and distribute interest in them in a more 
convenient manner. A slightly different plan was followed by 
the holders of the founders' shares in the original Suez Canal 
Company. There were 100 of these shares which were of no 
par value but which were entitled to 10% of the surplus profits. 
These 100 shares were divided into 100,000 and were sold on 
the open market. The customary arrangement is that 
founders', management, or deferred shares shall take one-half 
the profits remaining after the ordinary shares have received 
a given rate of dividend. 

Sometimes voting shares are subjected to peculiar restric- 
tions for the sake of forestalling any danger of losing control 
or of bringing into the management people who are not de- 



8 4 CAPITAL 

sired. The Imperial Tobacco Company, Ltd., which is a com- 
bination of the chief British manufacturers of tobacco, has 
but three or four hundred holders of its voting shares and 
is controlled by a much smaller number. In order to maintain 
its character as a "close" corporation, it has stipulated in the 
articles of incorporation that no shareholder may dispose of 
his shares except by offering them, through the company, to 
other shareholders at a price to be fixed by the shareholders 
from time to time. An exception is made with respect to the 
transfer of shares to members of the immediate family of a 
shareholder. The price fixed for transfers has always been 
considerably less than the probable market value. In 19 12, 
for instance, when 3% dividends were being paid, the price 
fixed was £2. In 191 3, when 35% dividends were being- 
paid, the price fixed for these transfers was increased only to 
£2 5s. 

In the United States small, close corporations sometimes 
attempt to accomplish the same result by means of by-laws 
prohibiting the sale of stock to anyone not already a stock- 
holder, or prohibiting the sale of stock without the consent of 
the directors, or unless it has first been offered to the directors 
at a price not greater than that at which it is subsequently to 
be offered or sold to outsiders. These provisions, however, 
are illegal and unenforcible. Nevertheless they are sometimes 
adopted, and printed on the face of stock certificates to give 
notice that outside purchasers are not welcome, and that what- 
ever rights they may obtain they will be able to enforce only 
through legal process. Sometimes stockholders agree among 
themselves to withhold their stock from outsiders. Such a 
contract would be legal as between the stockholders, but would 
not affect the rights of any outsider who might without notice 
and in good faith purchase some of the stock. On the whole, 
it may be said that restrictions of this nature have not proved 
effective in this country. 



OWNED CAPITAL 85 

The Montana Power Company has two classes of common 
stock. About $27,000,000 is receiving 2% dividends, while 
dividends on $22,500,000 are "deferred" until certain new 
plants are completed, and are then payable only gradually over 
a series of years. Inasmuch as the New Jersey laws, under 
which the company is incorporated, do not authorize the pay- 
ment of dividends on part of an issue unless they are paid on 
the whole issue, this arrangement seems at first glance illegal. 
In response to an inquiry, however, the treasurer of the com- 
pany advises that: 

The stockholders owning $22,500,000 of the stock of 
this Company have agreed that, as to their stock, divi- 
dends may be deferred until a certain time, and that 
stock has been conveyed to certain trustees, who hold the 
same for the purpose of securing the provisions of the 
agreement with regard to deferred dividends. As any 
part of the stock becomes entitled to dividends, it will 
be released from the provisions of the trust agreement 
and will be distributed to those who are entitled to 
receive it. 

It appears, therefore, that this issue of "deferred" stock — the 
term was previously almost unknown in the United States — 
is made possible solely by voluntary agreement among certain 
stockholders. 

Another issue which is unusual is the "assenting" stock 
of the Westinghouse Electric and Manufacturing Company. 
This is an outgrowth of the reorganization of the company, 
in 1 89 1, at which time the common stockholders were asked 
to surrender 40% of their holdings and retain 60%. This 
60% was to be called "assenting" stock, and was to receive 
7% preferential dividends before the other common stock, no 
part of which was surrendered. In other words, the "assent- 
ing" stock became practically a second preferred and might 
have been so designated. 



86 CAPITAL 

Certificates of Stock 

A certificate of stock and the stock itself are two different 
things. The certificate is in the nature of a receipt. It cer- 
tifies that a given individual is the owner of so many shares, 
and usually gives a brief digest of the special conditions, or 
terms, if there are any, which govern these shares. The cer- 
tificate may be destroyed or lost, but neither contingency 
would in itself affect the ownership of the shares, or even the 
legal evidence of ownership which consists of the company's 
own register of stockholders and of the amount of their hold- 
ings. The loss or destruction of a certificate could ordinarily 
mean, therefore, only so much inconvenience. 

There are numerous technical questions with regard to the 
handling of stock certificates and the transfer of ownership 
of stock through delivery of certificates, which can only be 
touched upon here. In one recent case a stockholder had left 
his certificate, indorsed in blank, with a broker for safe- 
keeping. The broker fraudulently sold the certificate. It was 
pointed out by the courts that if the purchaser actually was 
innocent and was acting in good faith, he had received a good 
title, and that the presumption would be that he relied upon 
the indorsement made by the owner, inasmuch as such indorse- 
ment would be prima facie evidence that the owner intended 
to give the broker the right to sell the stock. If the certificate 
had been left without being indorsed, and no power of at- 
torney had been given the broker, so that he would have been 
compelled to forge the name of the owner, the purchaser 
would not have secured a clear title. 

A question frequently raised is, what is to be done when 
a stock certificate is lost? The secretary or transfer agent of 
the corporation should be immediately notified not to transfer 
it on the books of the corporation. It is usually difficult to 
procure another certificate, because the corporation must be 
protected against loss by the filing of a bond, and this bond 



OWNED CAPITAL 87 

must be kept in force so long as there is a possibility that the 
old certificate may turn up. Every state has its own statute 
of limitations showing how long an obligation of this kind is 
to be regarded as legal and enforcible. The important point 
that should be kept in mind in connection with all such matters 
is, that there is an increasing tendency, which nearly all deci- 
sions show, to make stock certificates strictly negotiable instru- 
ments, and as such transferable by indorsement without its 
being necessary to give further proof of ownership. It must 
be remembered that the holder of record of a lost certificate 
can vote and receive dividends as before. The loss of his 
certificate affects only his power to transfer his stock. 

As has been indicated, stock certificates of the larger cor- 
porations in the United States are always "registered," that 
is to say, the list of stockholders of a corporation is kept in a 
register, and transfers from one name to another are made 
on presentation of the stock certificate properly indorsed. In 
England a comparatively small amount of stock is "inscribed." 
In this case the holder is given merely a stock receipt, which 
has no special value or importance. Whenever it is desired 
to transfer stock holdings the owner must appear in person, 
or in the person of some one legally entitled to act as his 
attorney, at the office of the corporation and there attest 
the transfer by signing his name in the transfer book. This 
is too cumbersome a method to be practicable except for small 
or close corporations. 

A third form in which certificates may be issued is the 
"bearer" form. In the United States there are few, if any, 
bearer certificates of stock. In England they are used for 
preferred, guaranteed, and debenture stocks when the rates 
of dividend or interest are fixed, and when there is a definite 
date of redemption. Inasmuch as the ownership of bearer 
securities is not registered, the certificate itself is the sole 
evidence of ownership and must therefore be guarded with 



88 CAPITAL 

great care. Ordinarily, coupons (which are, in effect, a series 
of post-dated checks, one for each interest or dividend pay- 
ment) are attached and must be cut off and deposited for 
payment at the proper time. 

Par Value of Shares 

The par value of shares of stock may vary in any amount 
from as low as one cent to as high as thousands of dollars. 
In some states the minimum par value is fixed at $i, $5, or 
$10, as the case may be. Nearly all shares in the United 
States are $100 or less, with an overwhelming majority fixed 
at $100. The next most popular figure is $50, and then 
probably $25, $15, and $10. In recent years the tendency 
to issue shares without par value has grown stronger and 
stronger. 

There is also a tendency, which appears to be growing in 
strength, to reduce the par value of shares of many cor- 
porations that are looking for wide distribution of their stock, 
and especially of those corporations that desire to have their 
own employees become interested in the company as stock- 
holders. It is said that during a visit to England in 191 3 
George J. Whalen, president of the United Cigar Stores Com- 
pany, was much impressed by the fact that most English 
industrial and commercial shares have a par value of £1 or 
£2. Under his influence the par value of the United Cigar 
Stores stock has been changed from $100 to $10, the par 
value of the stock of the Corporation of Riker-Hegeman from 
$100 to $5, and the shares of the United Profit Sharing Cor- 
poration were brought out at a par value of $1. A number 
of important companies like the National Transit Company 
and the Eastern Steamship Company have made the par value 
of their shares $25. 

On the other hand, there are a number of instances of 
closely held shares which have an exceptionally high par value. 



OWNED CAPITAL go, 

Lalance and Grosjean Manufacturing Company, a New York 
corporation, has common stock of a par value of $500. The 
par of the stock of the Tribune Association, the company 
which publishes the New York Tribune, is $1,000. The par 
value of the stock of Tiffany and Company is also $1,000. 

Issue of Shares — Full-Paid and Partly Paid Shares 

The theory of the law is that all corporate securities are 
issued in exchange for cash, or other value, equivalent at 
least to the nominal value of the shares. If shares are issued 
without proper consideration, they may be cancelled as invalid. 
An important case in point was decided in the State of New 
York in 191 2. It appears, according to testimony, that at 
the time Henry O. Havemeyer was president of the American 
Sugar Refining Company, he undertook, in behalf of his com- 
pany, to purchase shares of the National Sugar Refining Com- 
pany and otherwise to help finance that concern. In return 
for his services he received $10,000,000 of the common stock 
of the National Sugar Refining Company. When suit was 
brought against his estate several years later for cancellation 
of this issue, it was decided by the courts that insufficient con- 
sideration had been received, and that the whole issue should 
be declared void. 

Some governments will not permit payment for stock to 
be made in anything except cash. The State of New Jersey 
allows payment in cash and property, excluding services. 
These limitations, however, are of no great practical im- 
portance, for it is a very simple matter to arrange for an 
exchange of checks which will satisfy the technical require- 
ments of the law and at the same time accomplish the identical 
purpose that would have been accomplished if property or 
services had been directly accepted in payment for the stock. 

In this country stock is seldom issued for less than its 
par value, and is seldom allowed to remain permanently "partly 



9 o 



CAPITAL 



paid." In England partly paid shares are common, especially 
in banking corporations. In this case the unpaid portion of 
the shares remains as a liability of the shareholder and is 
therefore a source of strength to the institution. In both 
countries, with very few exceptions, shares that are issued for 
cash, property, or services valued at less than the par value 
of the shares, carry with them an obligation on the part of 
the holder to pay up the difference at any time that the cor- 
poration — or the receiver for the corporation if it should be- 
come insolvent — may call upon him to do so. This liability 
does not, however, extend to an innocent holder for value. 

A bona fide purchaser for value and without notice 
of stock issued by a corporation as "paid up" cannot be 
held liable on such stock in any way, either to the cor- 
poration, corporate creditors, or to other persons, even 
though the stock was not paid up as represented. Such a 
purchaser has a right to rely on the representations of 
the corporation that the stock is paid up.* 

Partly paid stock may at some later date be made full-paid 
if the corporation prospers and accumulates a sufficient sur- 
plus to enable it to declare a stock dividend equivalent to the 
unpaid portion of the shares. Some time ago one Utah cor- 
poration, the stock of which had been only 20% paid, found 
itself in a position to declare an 80% stock dividend. There 
was probably no doubt about the legality and the propriety 
of this procedure. The corporation's surplus was genuine, 
and it was much better for the shareholders to be relieved of 
their obligation than to continue to carry so much of a surplus 
account. 

Under certain conditions shares may be sold by a corpora- 
tion below their par value and still be regarded as full-paid. 
The chief condition is that the corporation shall be in need of 



*Cook on Corporations, §50, 



OWNED CAPITAL g T 

funds and shall not be able, with reasonable effort, to dispose 
of its shares at or above their par value. In the same way an 
insolvent corporation may be permitted to issue some of its 
shares, in payment of its debts, at a price below the par value 
of the stock. 

Bonus Shares 

A question which often arises is that of issuing common 
stock as a bonus in connection with bonds or with preferred 
stock. It is common practice, for example, to sell the bonds of 
industrial and public utility companies at par with a 10%, 
20%, or some other percentage bonus of common stock. On 
the surface it appears that the stock is being given away, and 
that the purchasers and subsequent holders must assume a 
liability to pay its full par value on demand. Ordinarily, this 
offer is made, not directly by the corporation, but by a firm of 
bankers or brokers which has probably secured the common 
stock according to part of a contract which includes compensa- 
tion for their own services ; the stock has thus been made 
"full-paid." Even when the purchase is made direct from the 
corporation, however, it may involve no liability on the stock ; 
for technically the purchaser is supposed to pay the full par 
value of the stock and to take the bonds at a discount. In 
most of the states there is no statutory or common law which 
prevents the sale of the bonds or other obligations of a cor- 
poration at a discount. When common stock is issued as a 
bonus with preferred stock, the case may be different. Under 
such circumstances there are technical points which are va- 
riously interpreted in different jurisdictions. In the State of 
Washington, the Supreme Court has recently decided that 
persons* receiving shares of common stock as a bonus with 
preferred are liable for the par value of such stock, the accep- 
tance of the bonus stock carrying an implied promise to pay 
for it if payment is called for. 



9 2 



CAPITAL 



Watered Shares — Overcapitalization 

While it may seem that the corporation laws almost with- 
out exception prohibit the issuance of full-paid shares for less 
than the equivalent of their par value, and that it would be 
impossible, therefore, for a corporation to start out with a 
capitalization higher than the actual market value of its 
property, it is well known that in actual practice this- law is 
frequently ignored. 

The capitalization of many corporations does not corre- 
spond, or even tend to correspond, closely to the value of their 
assets. How is it possible to introduce this overcapitaliza- 
tion — or "water," as it is sometimes called — without acting 
directly in opposition to the law? The answer is to be found 
in the process of placing a valuation on the property or ser- 
vices acquired by the corporation. It is, of course, impossible 
to place an overvaluation on cash payments for stock. It is 
difficult to place an excessive overvaluation, even if it should 
be desired to do so, on tangible property that is accepted in 
payment for stock ; such property is for the most part of fairly 
stable and easily ascertainable value. But in the valuation of in- 
tangible property — good-will, patents, trade-marks, copyrights, 
organization, and the like — and in the valuation of special 
services, there is every opportunity to fix any figure that may 
be desired by the organizers of the corporation. It is not 
necessary to assume a wilful falsification of values in every 
instance in which a corporation is later shown to have been 
overcapitalized. Organizers are likely to be sanguine men 
who sincerely believe, at least for the time being, that the 
property they are acquiring has a remarkable potential value. 
By means, therefore, of the simple device of issuing stock 
for intangible property and services at whatever valuation the 
directors of a corporation agree upon, it is possible to adjust 
the capitalization of the corporation to suit the ideas and in- 
terests of the organizers of the corporation. 



OWNED CAPITAL 93 

The promoter of a mining company, to imagine an extreme 
case, thinks it possible to sell $1,000,000 par value of stock 
provided he can offer it at a heavy discount, say 10 cents on 
the dollar. His first step after incorporating his company 
is to procure a piece of property that may be represented as a 
prospective mine. He places a valuation of $1,000,000 on 
this property and sells it to the corporation — the directors of 
which are his own "dummies" — for $1,000,000 par value in 
stock. The promoter is then ready to sell his stock to the 
public at any price he may see fit to put upon it. The stock 
has been made full-paid because it has been issued for prop- 
erty which the directors have declared to be worth $1,000- 
000. This assumed transaction would probably be purely 
fraudulent. The same principle, however, is applied in or- 
ganizing many legitimate corporations. 

For instance, at the inception of the United States Steel 
Corporation, all the preferred and common shares, as well as 
its 5% gold bonds, were turned over to a syndicate of bankers 
headed by J. P. Morgan and Company, in exchange for $25,- 
000,000 in cash plus the stocks and certain bonds of the seven 
corporations which were at first taken into the combination. 
In view of the fact that some of the seven companies acquired 
had a considerable amount of water in their own capitaliza- 
tion, and inasmuch as the $1,300,000,000 stocks and bonds 
received by the syndicate had a much higher value than the 
market value of the stocks and bonds of the subsidiary com- 
panies, it is clear that the Steel Corporation started out with 
a large amount of water in its capitalization. The estimate 
of the market is shown by the fact that the common stock at 
first sold in the neighborhood of one-third of its par value. In 
this case the directors were free to place their own valuation 
on the securities of the subsidiary corporations which they 
acquired, and more especially on the services rendered by the 
syndicate which carried through the whole transaction. 



94 



CAPITAL 



As reference will be made from time to time in this volume 
to numerous other instances of overcapitalization, no further 
examples need be cited here. It may be remarked in passing, 
however, that the basic theory of the law that capitalization 
should always correspond to the actual market value of the 
assets of a corporation is, in the judgment of many competent 
thinkers, both impractical and unsound. 

It may be asked why the courts do not more frequently 
enforce a closer adherence to the intent of the law. The 
answer has already been partly indicated. The intangible 
assets and the services which are accepted by corporations in 
payment for their stock are difficult to value, and for this 
reason it is only in exceptional cases that bad faith on the 
part of corporations in making their valuations can be con- 
clusively shown. On the numerous occasions when this ques- 
tion has been involved, the courts have applied either one or 
the other of two rules, known respectively as the "true value" 
rule and the "good faith" rule. The true value rule, which 
has been applied in a number of instances during recent years 
by the courts of Maine and New Jersey, is to the effect that 
in case a wide discrepancy between the market value of prop- 
erty and the par value of shares for that property can be 
shown, it may be assumed that the directors were misin- 
formed; hence the shares issued for that property are not 
"full-paid," and the holders of these shares may be sued for 
the difference between the real value of the property and the 
par value of the shares they received. In a New Jersey case, 
in which the owner of a patent had received $1,000,000 in 
stock for his contrivance, after the owner's death his estate 
was found to be liable to the corporation for approximately 
$900,000. The other rule, which was formerly universal in 
the United States and which is still commonly applied, in- 
dicates that directors may be assumed to be acting in good 
faith and with proper information before them unless fraud 



OWNED CAPITAL 



95 



can be conclusively shown. It is well known that it is always 
a difficult matter to produce legal evidence of fraud. 

Shares without Par Value 

In view of what has just been said concerning the issu- 
ance of watered shares, it is clear that there is no necessary 
or even close relationship between the par value and the market 
value of the shares of many corporations. A glance at the 
daily list of sales on any stock exchange will substantiate this 
statement. In order to avoid all question in regard to over- 
capitalization and undercapitalization and concerning the value 
of property acquired in exchange for shares, a considerable 
number of corporations have adopted the plan of issuing shares 
without par value. The company makes no claim, either ex- 
pressed or implied, as to the value of the assets. Its balance 
sheet shows, instead of capital stock and surplus, simply the 
value of the equity which is divisible among the shareholders. 
Anyone interested, if he knows the number of shares out- 
standing, may figure for himself the book value of each share. 
This method furnishes probably the simplest and most satis- 
factory means of handling the whole question of capitalization 
and of valuation of property and services. Among the cor- 
porations which have adopted this system are the following: 
the Submarine Boat Corporation, which was chartered in New 
York in August, 191 5, with 800,000 shares of no stated par 
value ; the Kennecott Copper Company, w r hich is understood 
to be a Guggenheim enterprise ; the Adams Express Company; 
the Amoskeag Manufacturing Company; and Montgomery, 
Ward and Company. 

Methods of Voting 

In the United States the well-established custom is to 
allow, for every share of voting stock, one vote in the election 
of directors and in the decision of other questions that come 



9 6 



CAPITAL 



before shareholders. As a result, the larger shareholders ex- 
ercise almost complete control. Not only do they possess the 
greater number of shares, but they have a large enough finan- 
cial interest at stake to make it worth while for them to take 
an active part in' the affairs of the corporation. The small 
holder, on the other hand, feels that he can exercise no real 
influence, and that it is not worth his while to attend meetings 
or even to send in a proxy, or written authorization, to some 
officer or other person present to act for him. 

In the United States Steel Corporation those shareholders 
who own 1,000 or more shares each, have in the aggregate a 
larger number of votes than the vast majority of smaller 
stockholders. It is safe to assume, therefore, that even in so 
large a corporation these comparatively few men are the ones 
who are keenly and directly interested as shareholders, and 
take the trouble to try to elect directors who will represent their 
views. It is for this reason, primarily, that in the United 
States complete control of a corporation may be obtained by 
one man, or by a group of men, who own perhaps only a small 
percentage of its outstanding stock. This has been notably 
true of some of the large railroad systems. It is stated that 
at the time when George J. Gould was in undisputed control 
of the Wabash and the Missouri Pacific railroads, he and his 
family never had more than 12% of the outstanding stock. 
It is said that the control of a bank or a trust company may, 
under ordinary conditions of stock ownership, be retained by 
the holders of 30% of the outstanding stock. 

In English practice a different principle as to voting is 
customarily, though not universally, followed. In order that 
complete domination by the large shareholders may be pre- 
vented, a limitation is placed on the number of votes that may 
be cast by any one shareholder ; or, instead, a regressive scale 
is so arranged that the number of votes does not increase in 
proportion to the number of shares. This practice dates back 



OWNED CAPITAL gy 

several generations. The "Companies Clauses Consolidation 
Act" of 1845 provides that whenever no scale of voting is 
prescribed in the by-laws, every shareholder shall have one 
vote for every share he holds, up to 10; an additional vote 
for every 5 shares, up to 100; and an additional vote for 
every 10 shares beyond 100. The Sheffield United Gas Light 
Company allows a shareholder not more than 30 votes; the 
London Gas Light and Coke Company, not more than 10 
votes; the Bristol* United Gas Light Company, not more than 
5 votes; the Black Pool Tower Company, not more than 20 
votes. It is said that attempts to evade this restriction are 
uncommon and that attempts to purchase control of established 
corporations in order to bring about combinations, and for 
other purposes, are not nearly so frequent in England as in 
this country. There are obvious advantages in this practice 
that are well worth considering, particularly those that have to 
do with the enlistment of the active interest of the smaller 
shareholders and the interposition of obstacles to exploitation. 
It is quite possible that the practice might be adopted to ad- 
vantage, especially by local corporations which may have meet- 
ings of shareholders from time to time, and in which the per- 
sonal influence of these shareholders is of real importance and 
value. 

Cumulative Voting 

The obvious injustice and danger of permitting the holders 
of a majority of the voting stock — or rather, in many cases, 
the officials and others who can most easily procure for them- 
selves the right to represent the majority of voting stock — 
to elect all the directors, and thereby to take full and unre- 
stricted control into their own hands, has led to the growing 
popularity and the very general adoption of another method 
of voting: namely, the cumulative method. 

Cumulative voting may be defined as a method whereby 



9 8 



CAPITAL 



each shareholder may cast as many votes as he holds shares of 
stock, multiplied by the number of directors to be elected. A 
shareholder may cast all of his votes for one, or two, or more 
candidates, or he may distribute them in any other proportion 
he sees fit. Thus the minority shareholders may so combine 
and concentrate their votes as to make certain of electing one 
or more representatives to the board of directors. 

To illustrate, let us assume that a corporation has 1,000 
shares outstanding, 600 of which are in the 'hands of a major- 
ity party, and that five directors are to be elected. Under 
the usual system of allowing one vote to each share and vot- 
ing for each director separately, the majority shareholders 
may pick out the full board of directors without any reference 
whatsoever to the wishes or interests of the minority. Under 
the cumulative system of voting, the majority party would 
have 5 times 600, or 3,000 votes altogether, at their disposal, 
and the minority party would have only 2,000 votes. If the 
majority party should attempt to elect all five directors, they 
could give only 600 votes to each one of the five ; the minority 
party could meet this move by concentrating their 2,000 votes 
on three directors, giving each one 666 votes, and thus elect 
a majority of the board. In order to make themselves secure, 
the majority party, presumably, would concentrate on three 
directors, each one of whom would get 1,000 votes; and the 
minority party would concentrate on two directors, each one 
of whom would receive 1,000 votes. Each party would thus 
secure representation on the board in exact proportion to its 
shareholdings in the corporation. In practice the situation 
would never be quite so simple, but the result of giving rep- 
resentation in approximate proportion to shareholdings would 
be obtained. 

There appears to be no question but that cumulative voting 
tends to prevent injustice and exploitation, and that it leads 
to a more active interest on the part of the smaller share- 



OWNED CAPITAL 99 

holders, who have under this method a better chance to secure 
representation. Among the large companies which have 
adopted cumulative voting are the Anaconda Copper Mining 
Company and the Ingersoll-Rand Company. Cumulative vot- 
ing is permitted by the laws of practically all the states, and 
is specifically required in some, including Pennsylvania and 
Illinois. 

Stockholders' Meetings 

The larger corporations in the United States make it their 
custom to send out notices of annual meetings to all stock- 
holders, and to forward with these notices a printed proxy, 
which authorizes the secretary or some other officer of the 
corporation to represent the shareholder at the annual meet- 
ing. Most of the corporations supply stamped envelopes and, 
if they do not hear from the shareholder, forward a second 
request for his proxy. All that the shareholder is asked to do 
is to sign his name, enclose the proxy in the envelope and 
mail it. Nevertheless the interest on the part of the average 
shareholder is so slight that only a small proportion of these 
proxies, it is stated, are ordinarily returned. It is easy enough 
to return the proxy, but it is just a trifle easier to drop it into 
the waste basket. Probably the average shareholder sees no 
reason why he should take action one w T ay or the other. He 
does not know whether the corporation is being well-managed 
or whether the officers and directors deserve his- support or 
not. Except in very unusual cases, when there is an opposi- 
tion and when a campaign to get his support is carried on, 
he knows that his vote will have not the slightest influence 
either for or against any man or measure. 

Usually the secretary and one or two other officials of the 
corporation take the proxies to the annual meeting, go through 
all the formalities of electing a chairman and a secretary, pre- 
senting reports and casting votes, and carry out whatever 



IO o CAPITAL 

programme has been agreed upon by the officers of the cor- 
poration. Every year, for instance, an officer of the Union 
Pacific Railroad Company takes a satchel full of proxies, 
makes the trip from New York to Salt Lake City (the Union 
Pacific Railroad Company being incorporated in Utah) and 
holds the annual meeting. Even when action out of the or- 
dinary is proposed, very few shareholders ever take the trouble 
to attend these meetings. 

At the annual meeting of the Northern Pacific in 1914, 
authority was asked for a new issue of $750,000,000 in bonds. 
Some of the shareholders objected to the looseness of the 
authority asked, but the plan was carried through without 
effective opposition by voting the proxies previously collected 
by the officers. An amusing account of this meeting appeared 
in the New York Annalist of June 15, 1914, from which the 
following paragraphs are quoted: 

Eighteen shareholders, one for every one thousand 
stockholders, were on hand to see that justice was done to 
their interests. Four of these were directors, one was 
Chairman of the Board, another a former Vice-Presi- 
dent; .... but the strength of the meeting was not 
in the number present. When the Secretary took his 
place, he brought with him proxies for 1,387,202 shares 
of stock — nearly 56% of the total outstanding. The stock- 
holders might have talked their heads off, and voted as 
a unit against the bond issue, and still it would have 
gone through when the Secretary put down 1,387,202 
shares in its favor. 

Colonel Clough (the Chairman of the Board) sat in 
a high-backed chair at the head of a long table, looking 

an embodiment of the spirit of impartiality He 

had a courteous manner for each speaker, and in the pile 
of proxies he had a steam roller to run over objections 
when it came to a vote. 

After the reading of the resolution, Christian F. Leng 
arose to call attention to a small omission in the resolu- 



OWNED CAPITAL IOI 

tion. Not belligerently, but as one seeking to correct 
an oversight, he asked the Chair to state the amount of 
the proposed mortgage. He characterized the resolution 
as somewhat vague on that, to him, important point. 

The Chair was sorry the gentleman did not under- 
stand corporation matters better. The amount was to be 
left to the wisdom of a Board of Directors chosen by the 
stockholders to safeguard their interests. They would 
study the matter from every angle, lunch over it, and 
sleep on it, and in the course of time arrive at the total. 

It seemed that Mr. Leng was inclined to be stubborn. 
He said the Chair evidently had failed to understand his 
question, which had nothing to do with the province and 
wisdom of Directors, but concerned the amount of the 
proposed mortgage. As the owners of the corporation, 
he thought the shareholders entitled to know from their 
agents the amount to which they proposed to bond the 
property. "Is it not a reasonable inquiry to ask how 
much you propose to make this mortgage?" he concluded. 

The Chair again set about the enlightenment of the 
Philistine. Patiently he explained that were the stock- 
holders to determine the amount of the mortgage they 
might be kept in session for several days. That was a 
task for the Directors, a labor which the shareholders 
should be glad to escape. The Directors were in office 
solely to look after the interests of the stockholders. 
They would canvass the situation, look at it by and large, 
dig into figures, and attempt a forecast of the future. 
The Chair was a master of circumlocution, and always 
patient. 

Arose Mr. Leng again, to say that when he put a 
mortgage on his property he did not give a lawyer carte 
blanche to make it as large as he could. He suspected 
that the management had already decided on a figure; 
what he wanted to learn was the figure. To which the 
Chair replied that the Directors could be trusted to do 
what was right in the matter. 



The meeting having lasted as long as conventional 
shareholders' gatherings should continue, the steam 



I02 CAPITAL 

roller was started gently. A vote on the original resolu- 
tion was called for. On the proposition to authorize the 
Directors to proceed with their plan, the Secretary an- 
nounced: "Against, 400 shares; in favor of, 1,387,700." 
The meeting was adjourned. 

Voting Trust 

The "voting trust" has been growing in favor during 
recent years. It has already been mentioned that at one time, 
a generation or more ago, the favorite form of combination 
among competing concerns was a body of trustees to whom 
controlling shares in the competing corporations were turned 
over — an arrangement found to be in restraint of trade and 
therefore illegal. The plan herein referred to is different, 
in that it is confined to one company and its sole purpose is 
to secure continuity of management and policy within that 
company. 

The laws of most states which authorize the formation of 
a voting trust require that it shall be open to all shareholders 
who wish to take part in it. Without this provision it might 
become a dangerous device for concentrating control. In 
fact, even with this restriction there is reason to think that 
the voting trust has sometimes been used rather for the benefit 
of the trustees than for the benefit of the corporation. 

The chief use — and a legitimate use — of the voting trust, 
however, is to protect the shareholders and others who take 
part in a reorganization. Ordinarily, as we shall see later on, 
a reorganization is carried through by a banking syndicate, 
headed by some powerful banking firm. Naturally the firm, 
in order to protect its own reputation and the people to whom 
it has sold the securities of the reorganized company, wishes 
to make sure that there will be sound management over a 
period of years. Yet it is not in control and perhaps holds 
very little of the company's stock. In order to meet this situa- 
tion, it is frequently required that a majority of the voting 



OWNED CAPITAL I0 3 

stock be lodged with trustees under a voting trust agreement. 
Stuart Daggett states that out of seven railroad reorganiza- 
tions, during the period 1893-1898, five included voting trusts 
and one a proxy committee in the reorganization plans. 

A similar use of the same plan is the establishment of a 
voting trust representing the preferred shareholders when 
there has been default in payment of the preferred dividends. 
Under the laws of New Jersey, a voting trust cannot continue 
for longer than five years, and other states have imposed 
similar limitations. Ordinarily, the trustees have an option 
to terminate the arrangement at their discretion. When the 
Northern Pacific voting trust was dissolved in 1901, the trus- 
tees explained the dissolution: ''by reason of the evidence of 
financial strength, conservative management, skilful and prof- 
itable operation, superior physical condition of the property 
and reasonable prospect of continued prosperity/'* 

Still another use of the voting trust is to prevent the con- 
trol from passing into the hands of interests that are not 
regarded favorably by the management of the corporation. 
When the American Glucose Company was formed, in 1894, 
the vice-president of the company controlled a clear majority 
of the stock, but it was agreed, nevertheless, that the active 
management should be in the hands of the president. An 
agreement was therefore signed "to place in the hands of 
trustees, to be named by the President, 2,544 shares of said 
preferred stock, upon the trust that in the election of the 
directors and officers of said company, and upon other matters 
arising at stockholders' meetings, said trustees shall vote 
thereon as requested by said President." The addition of the 
trustees' stock to the president's own holdings gave him control 
of the company and enabled him to elect four out of the seven 
active members of the board. 

Among the various important corporations in which there 

*Stuart Daggett's "Railroad Reorganizations," p. 310. 



I0 4 CAPITAL 

are now voting trusts, may be mentioned the Buffalo Electric 
Vehicle Company ; William Cramp and Son, Ship and Engine 
Building Company ; General Motors Company ; Intercontinen- 
tal Rubber Company; International Mercantile Marine Com- 
pany; Lehigh Coal and Navigation Company; J. I. Case 
Threshing Machine Company ; Loose- Wiles Biscuit Company ; 
Hale and Kilburn Company ; and Allis-Chalmers Manufactur- 
ing Company. 

Among smaller corporations the voting trust is somewhat 
unusual. In many cases it might be found a legitimate and 
helpful means of securing agreement and continuity of 
policy. 



CHAPTER VI 

BORROWED CAPITAL— SHORT-TERM 

Advantages of Borrowing 

'The habit of borrowing," says Hartley Withers, "is a 
modern invention." There was formerly a custom among all 
well-ordered governments and business enterprises, of amass- 
ing treasure for use in emergencies ; without hoarded treasure 
even the largest owner of property would have been help- 
less. Today the wisest financial policy is to pile up not 
treasure, but credit. To be sure, sound credit may require the 
possession of a certain proportion of gold and securities ; but 
this treasure no longer exists for its own sake so much as for 
a support and guarantee to credit. 

More and more as credit facilities increase and credit 
machinery works more smoothly, business enterprises are 
financed with borrowed capital. The great advantages of 
borrowing are its cheapness and its ease. It is cheaper to 
borrow than to secure a co-owner or a group of co-owners for 
a business, because of the greater security that is offered to 
the lender. To put the same thought in terms of corporate 
financing, first-class bonds may be sold on a 4, 5, or 6% basis, 
whereas preferred shares sell on a 6, 7, or 8% basis, and 
common shares on a still higher basis. Hence, the larger the 
proportion of capital which the individual or corporation can 
borrow, the larger is the yield on the owned capital. 

Take a very simple illustration. Suppose a corporation 
with $100,000 capital is regularly earning 10%, or $10,000, 
a year; let us say that $20,000 of the capital is borrowed at 
5%, making the interest payment $1,000. Then the $80,000 
of owned capital will have left an income of $9,000, or a 

105 



I0 6 CAPITAL 

little over 11%. Let us now make the assumption that the 
business is of such a character that $80,000 can be borrowed 
at 5%, making the annual interest payment $4,000. In that 
case the $20,000 of owned capital will have left an income 
of $6,000, or 30%. 

We have here an explanation of the profit-making possibili- 
ties — when properly financed — of enterprises which yield only 
a small average return on the invested capital. Most public 
utility companies, for instance, secure only a moderate yield 
on their actual investment, but these companies hold properties 
which can be mortgaged up to a high percentage of their 
value. Hence, at least one-half the capital is borrowed and 
the owned capital may obtain very good dividends. Accord- 
ing to the Electrical Railway Review, the issued stock of all 
the electrical railways in the United States for 19 12, had a 
par value of $2,945,000,000, and for 191 3, $2,808,000,000, a 
decrease of $137,000,000. The bonded indebtedness of these 
companies for 19 12 was $2,641,000,000, and for 19 13, $2,- 
814,000,000. We see here not only a large proportion of 
borrowed capital, but its rapid increase from year to year, 
with a corresponding decrease in owned capital. The same 
thing is true of real estate operations. An extreme case is 
that of a New York corporation known as the "Forty-two 
Broadway Company," which has a capital stock of $600 and 
a bonded indebtedness of nearly $5,000,000. 

As to the ease of borrowing, it is perhaps sufficient to call 
attention to the immense quantities of bonds and notes which 
are continually being issued and sold. Modern efficiency and 
productivity are piling up wealth at a faster rate than ever 
before. And the security of property — except as it may be 
disturbed by tremendous international conflicts — is increasing. 
Now the first thought of a man who has only a little money 
is to increase that little, and he is willing to take chances in 
so doing. For that reason, it is among poor people, and 



BORROWED CAPITAL— SHORT-TERM 



107 



especially poor people of the professional classes, that the 
swindling promoter finds his easiest victims. But a man who 
has a comfortable amount of property is looking for safety 
rather than for increase. Hence, as the average wealth of a 
country increases, not only is more and more capital released 
for investment, but a larger proportion of that capital is look- 
ing first of all for safe investment. In other words, its owner 
prefers to lend it rather than to take greater chances as a 
proprietor or part proprietor. 

Another factor working in the same direction, is the piling 
up of enormous funds held in trust; estates that are being 
directed by trustees; the funds of life insurance companies; 
the funds of savings banks and the like. All these trust funds 
are available only for lending on excellent security. For these 
reasons a man or a corporation who can put enough owned 
capital into a substantial enterprise to furnish a reasonable 
margin of safety, will generally find it a comparatively simple 
and easy task to borrow the remainder of the needed capital. 

What has been said applies more especially to long-term 
or ''funded" borrowing, but much the same statements hold 
true on short-term borrowing. "Through all business activi- 
ties," points out the Nezu York Annalist, "there is more capital 
needed today than used to be needed, but it is wrong to take 
it for granted that an individual needs to have more money 
to go into business."* 

The explanation for this apparent paradox is to be found 
in the free use of credit which is a striking characteristic of 
all present-day business enterprises. Manufacturers, whole- 
salers, and bankers are always ready to extend credit freely 
to young men of ability and character. The silk industry is 
notable for the amount of business that can be done on a very 
slim margin of capital. Raw silk is sold to manufacturers on 
a credit basis that resembles "memorandum credit" among 



'New York Annalist, April 17, 1914. 



I0 8 CAPITAL 

jewelers. Many factories are rented entire. It is said that 
in Philadelphia the extensive cotton industry is in large 
measure carried on in the same way. Lofts with power and 
machinery are rented ; materials are obtained on a credit basis. 
The United Shoe Machinery Company has for many years 
made a practice of furnishing its machines only on lease; it 
does not sell them. In this industry, therefore, a man with 
large capital has no great advantage, so far as obtaining effi- 
cient machinery is concerned, over a man with small capital. 

Proportions of Borrowed Capital 

In England the distinction between preference shares and 
"debenture" shares or other forms of obligation, is so hazy 
that owned capital almost imperceptibly merges into borrowed 
capital. Partly for this reason, the proportion of borrowed 
capital often appears somewhat smaller than in this country. 
For example, in water, railway, tramway, gas, and other 
public utility companies, the amount of loaned capital is usually 
limited to one-third of the total capital. The Board of Trade 
in railway returns for 19 10 showed percentages of the various 
classes of railroad securities as follows :•* 

Ordinary stock 37-3% 

Preference and guaranteed stock 35-8% 

Loan and debenture stock 26.9% 

It will be noted that much of the preference and guaranteed 
stock would normally be considered as borrowed capital in 
this country, so that actual practice in the above classes of 
undertakings does not differ much from the practice in the 
United States. 

The first schedule of the English Companies Consolidation 
Act of 1908, provides that the indebtedness of a company shall 

*Robert H. Whitten's report on "Regulation of Public Service Companies in 
Great Britain," issued by the Public Service Commission, 1st District, State of New 
York, 1914, pp. 26 ft. 



BORROWED CAPITAL— SHORT-TERM IO o, 

not at any time exceed the amount of its capital without the 
sanction of the shareholders in general meeting. 

Against the two great advantages of using borrowed capi- 
tal — cheapness and ease in procuring the funds — there must 
be offset the obvious disadvantage, that the risk to the owners 
of the share capital is thereby increased. The shareholders 
have, of course, only an equity in the property and income of 
the corporation which is first subject to all prior claims of the 
holders of the obligations. This may not involve a serious 
risk in the case of corporations that have stable earnings, but 
when earnings fluctuate widely from year to year, even though 
the average return on the invested capital may be high, the 
position of the shareholders with a large indebtedness ahead 
of them may become very uncomfortable. It is for this reason 
that the tendency has been strong in recent years for indus- 
trial corporations to shun even small bond issues and to raise 
their capital only through common and preferred shares. 
Sometimes this cautious policy may be carried to what appears 
to be an extreme. Two large and powerful industrial corpora- 
tions, for instance, the Pullman Company and the Singer Sew- 
ing Machine Company, have no securities outstanding except 
common stock. Two somewhat smaller corporations which 
have cleared away all their obligations, including even short- 
time notes and accounts, are the Plume and Atwood Manu- 
facturing Company, in Connecticut, and the United Shoe 
Machinery Company. 

The unsoundness of too heavy borrowing cannot be better 
shown than by the combined figures on the capitalization of 
thirteen large railway systems in the United States which 
were in receivers' hands in the summer of 1914. The funded 
debt of these thirteen railways was about 70%, and the stock 
issues only about 30% of their total capitalization. 

To lay down any exact rules as to the proper proportion 
of borrowed capital, would clearly be out of the question. We 



HO CAPITAL 

are forced to fall back on the general statement that capital 
should not be borrowed unless there is a practical certainty 
that both interest payments and payments on principal can be 
met as they fall due. This involves the further rule that the 
annual fixed payments of a corporation should be only a 
reasonable proportion, not of the average earnings, but of the 
lowest earnings. The fact that a corporation has made a dis- 
tribution or invested big profits in one year, is small comfort 
if it finds itself in the following year unable to meet its ob- 
ligations. 

As to payments on account of principal, it has long been 
regarded as almost axiomatic that companies doing a stable 
business, such as railways and public utilities, need make no 
provision for paying oft and retiring their funded debts. 
These companies, it has sometimes been said, will never cease 
to borrow; therefore, when one obligation matures, the proper 
plan is to refund it by issuing another obligation in its place. 
However, this principle is no longer universally accepted. In 
fact, at the 191 5 meeting of the Investment Bankers' Associa- 
tion, the Committee on Railroad Bonds and Equipment Trusts 
recommended among other things that railroad mortgages 
should contain provisions for sinking funds. Even railroad 
corporations, if this recommendation were generally adopted, 
would be taking steps to pay off in cash each obligation which 
they incurred. 

Forms of Borrowing 

All borrowing is of two general classes, "short-term" and 
"long-term." This is by no means purely a verbal difference, 
for there are clear market distinctions between the principles 
that apply in these two classes. Just where we should draw 
the line between the two is a difficult question to answer; it is 
largely a matter of usage. In Wall Street, "short-term" 
usually refers to obligations having not more than five years 



BORROWED CAPITAL— SHORT-TERM Iir 

to run; "long-term" usually refers to obligations having, say, 
twenty years or more to run from date of issue. Obligations 
running in intermediate periods might be put in either one or 
the other of the two groups. The question is not of much 
importance; for apart from the securities know T n as "equip- 
ment notes," there are very few which fall within the five-year 
to twenty-year limits. The chapter which follows will be 
devoted to "long-term" securities, so that nothing more need 
be said about them here. 

Short-term securities consist of notes, of acceptances, and 
of accounts payable. The notes are divided into three well- 
marked classes: (i) merchandise notes, (2) notes discounted 
at banks, and (3) notes sold to the public. For our present 
purpose, we will group accounts payable, acceptances, and 
merchandise notes under the head of "trade credit." After 
considering this subject, we will take up bank credit and notes 
sold to the public. This is a convenient division of short-term 
borrowing which conforms to commercial practice. 

Trade Credit 

The fact that all the trade credit which a business normally 
utilizes is in fact a method of borrowing capital, seems to be 
overlooked; yet it is the chief source of capital in many con- 
cerns which do a trading business. There are literally tens 
of thousands of small merchants throughout the country who 
customarily buy nearly all their stock in trade on credit, and 
whose own capital is no more than sufficient to cover the pur- 
chase of store fixtures and perhaps some small advances on 
their first orders as a guarantee of their good faith. It is out 
of the question for them to pay their accounts with the whole- 
salers from whom they buy, until after they have sold the 
goods and thus have secured cash funds from their customers. 
Very often the wholesaler in his turn is "carried" to a great 
extent by the manufacturers and jobbers from whom he buys; 



112 CAPITAL 

his proportion of owned capital, however, is likely to be much 
higher than the retailer's proportion. Going one step further 
back we reach the manufacturer with whom trade credit is 
comparatively a minor source of funds. Thus we have the 
whole process of selling goods through the ordinary trade 
channels financed to a considerable extent by the extension of 
credit. The ultimate customer is the only man in the chain 
who pays cash — and even the customer may in his turn be 
living on trade credit. As the customer pays for his purchases, 
the retailer is able to collect current funds which he transmits 
to the wholesaler, who in turn pays the manufacturer and 
jobber. 

The extent to which trade credit is granted, depends chiefly 
upon the nature of the goods that are being retailed, and on 
the ability of the ultimate consumer to pay promptly. Some- 
times extreme instances are found in which a whole community 
or a whole country is doing business largely on "trade credit." 
In Argentina, for example, during the several years preceding 
the beginning of the European War in 19 14, all trade was 
handled on the basis of long credit. The importer of manu- 
factured articles had become accustomed to receiving 90-day 
drafts (which is the usual term of drafts representing ship- 
ments from Europe or the United States to South American 
countries), and these drafts he was frequently able to renew 
for a like period; so that the importer was getting three 
months' to six months' credit on all his purchases. The im- 
porter in turn sold to country storekeepers on "open account" 
and was compelled to wait for his payment until the store- 
keeper could collect from his customers. The customers were 
for the most part land owners who had funds only at one 
season of the year, after the sale of their crops; consequently, 
the storekeeper was in the habit of securing three months' to 
nine months' terms for himself. Thus all business was being 
done on "long credit" and the proportion of owned capital 



BORROWED CAPITAL— SHORT-TERM II3 

invested in retail, wholesale, and importing houses was ab- 
normally small. By reason of the wonderful resources and 
prosperity of the country, this system worked fairly well for 
a number of years and made possible enormous profits in all 
lines of trade. Its danger was shown, however, when suc- 
cessive poor crops in 19 12 and 191 3 impaired the paying ability 
of the Argentine farmer and led to an enormous number of 
mercantile failures.* 

Much the same situation and practices existed in the United 
States a generation or more back. Prior to the Civil War, 
purchases of merchandise were customarily settled by notes 
running six, eight, or ten months and sometimes longer. This 
was due to the fact that buyers came to market only once or 
twice a year, and then purchased their entire stock for the 
season, the buyers giving their notes which were readily in- 
dorsed and discounted. These were usually met out of the 
proceeds of the sale of the goods to the ultimate consumer. 
The Civil War upset this system. During the war and for 
some years after, merchandise business came down to a basis 
of cash or of credit of only ten to thirty days. When the 
next great expansion of trade took place in the early 8o's, 
the increased confidence of sellers resulted in offering some- 
what longer terms of credit, but these terms were combined 
with offers of liberal discount for cash payments, which is 
the custom in most lines today. The discounts were so attrac- 
tive that retail merchants in good standing began to borrow 
from their local banks in order to take advantage of them. 
Thus the present practice of taking discount for cash was 
established ; and prices are now made with that understanding. 
The high rates of discount are now in the nature of a penalty 
imposed on a merchant who takes the long terms which are 
nominally at his disposal. This change in custom of payment 

*For a more detailed study of this situation see the author's report on "Financial 
Developments in South American Countries," issued by the Bureau of Foreign and 
Domestic Commerce, Washington, D. C 



!!4 CAPITAL 

was accompanied by the introduction of the commercial 
traveler, selling from sample in comparatively small lots. The 
process has been helped somewhat by the standardization of 
goods and selling methods, and the quicker turnover which 
has now become possible.* 

For these reasons, trade credit in this country is relatively 
less important, and bank credit is more important, than was 
formerly the case. Another factor which should be mentioned 
as contributing powerfully to this result is the decentralized 
banking system of the United States, which puts one or more 
local banks at the door of every merchant and makes it com- 
paratively easy for him to secure and utilize bank credit. 

The European system of financing merchandise purchases 
rests upon the use and discounting of accepted drafts which 
are in effect two-name promissory notes. The wholesaler 
draws a time draft upon the retailer which accompanies the 
shipment of goods. The retailer writes or stamps his accep- 
tance on the draft across its face and returns it to the whole- 
saler who is then in position to discount it with his bank. 
This is a method of financing merchandise transactions which, 
from the banker's standpoint, has a number of advantages, the 
chief of which is that every accepted draft represents an actual 
transfer of goods, and the banker is not compelled to lend, 
therefore, merely on the strength of the general credit stand- 
ing of his customer. An effort is now being made, under 
the guidance of the Federal Reserve Board, to introduce this 
system in the United States. Although the movement is of 
genuine importance, we need not for our purposes consider 
it further. It is closely similar to the custom which prevails 
in certain lines of business of giving notes in payment for 
purchases of merchandise. 

Some of the principal lines in which note-giving is still 



*See an excellent article entitled "Proposal to Dehumanize Trade," by E. D. Page 
in New York Annalist, March 16, 1914. 



BORROWED CAPITAL— SHORT-TERM 



115 



common are harvesting machines, plumbers' supplies, book 
printing and binding, and electric trolley supplies. In most 
other lines, however, goods are sold on open account and notes 
are asked for only when the sale is made to a weak concern. 
Sellers are often so anxious to dispose of their products, and 
it is consequently so easy for established firms that have a 
clean record behind them to secure whatever goods they re- 
quire on terms of 30 to 90 days or even longer, that trade 
credit may almost insensibly become a real source of danger. 
It is a delicate instrument which requires to be handled with 
watchfulness. A little carelessness in failing to meet trade 
accounts on the day they fall due may be sufficient to give a 
concern the reputation of being "slow pay," and thus may 
damage not only its credit with the firms from which it buys, 
but also its credit with banks as well as its general business 
standing. 

On the other hand, there is undoubtedly such a thing as 
being overzealous in paying up trade accounts. Not only is 
there an actual loss of capital to the extent of the difference 
between a normal amount of trade credit and the amount 
which the company secures, but there is also to be considered 
the fact that the habit of paying accounts ahead of time, once 
it has been formed, cannot be easily broken. The writer has 
in mind one concern which started in business with ample 
funds. The treasurer saw no reason why he should utilize 
the credit of the firm and paid all bills in cash as they were 
presented, even though he obtained no discount. A year or 
two later the expansion of the company's business reduced the 
available cash, and the treasurer began to take the full term 
of payment to which he was entitled. Immediately some of 
his creditors became suspicious as to the solvency of the com- 
pany, and rumors spread about which were so serious that 
it was necessary to bring more cash into the concern and 
resume, for the time being at least, the prompt payment of 



IX 6 CAPITAL 

bills. Thereafter the company proceeded by slow degrees to 
utilize the full line of trade credit to which it was entitled. 
There is much truth in the remark that the only way to acquire 
credit is to make use of it. 

Bank Credit 

It has already been noted that it is customary in this country 
for merchandising firms to take advantage of cash discounts 
in paying for their purchases and to secure the funds with 
which to make immediate payments by borrowing from their 
own banks. This practice spread throughout the country be- 
ginning in the 8o's, but it originated in New York several 
years before. Shortly after the crisis of 1873, the late presi- 
dent of the Importers and Traders National Bank in New 
York City, Mr. Buell, rapidly built up the business of his 
institution by showing his customers how, by borrowing from 
his bank on their own single-name paper, they could obtain 
cash prices or cash discounts and thus show a substantial profit 
on their interest and discount accounts for the year. The cus- 
tom is now so firmly established that practically every business 
concern in good standing counts on establishing a line of 
credit with its bank which will enable it to borrow simply by 
drawing its own notes and depositing them with the bank. 

A variation in this custom exists among large manufactur- 
ing and commercial corporations which often find it ad- 
vantageous to turn over their own notes to brokers who for 
a small commission sell them to any bank that may happen 
to have idle funds available. The note brokers sell the paper 
of large concerns throughout the country. At the time of the 
failure of the Booth Fisheries Company some years ago, and 
at the time of the more recent failure of the H. B. Claflin 
Company and associated concerns, it was found that the notes 
of these companies were scattered among banks throughout 
the United States. The banker who buys a single-name note 



BORROWED CAPITAL— SHORT-TERM ny 

from a broker, very often has no knowledge whatever of the 
financial affairs of the company which issues the note. He 
may have heard the name of the company frequently and he 
probably considers the note broker a good fellow in whose 
honesty and judgment he has confidence, and that is the extent 
of the actual information before him when he makes his pur- 
chase. This loose method of doing business has brought 
some protest and is likely to be improved in part during the 
next few years. 

A few large concerns which sell their short-term notes in 
the open market on a large scale, headed by the International 
Paper Company, have instituted the custom of having all their 
notes registered by a trust company, just as bonds are reg- 
istered. This has at least the advantage of making it easy 
to ascertain how many notes a company has outstanding at 
any one time, thus avoiding gross overissues. A second im- 
portant improvement is to be made a feature of the Federal 
Reserve banking system. It is the intention to place a com- 
plete record of the note obligations of all important concerns 
in the hands of members of the system. This record will, of 
course, include references to any defaults of bills in payment. 
In the course of a few years it will become a highly valuable 
aid to bank examiners and to the Federal Reserve officers in 
checking up the credit standing of borrowing companies. 

One accepted rule which should be observed by corpora- 
tions that sell their notes through brokers, is that they should 
not at the same time be discounting any large quantity of 
notes with their own banks. If they are using both banks 
and note brokers, they have no quick method of raising funds 
open to them in an emergency. If they are using either their 
own banks alone or note brokers alone, then they can turn, 
if it should become necessary, to the method that has not 
previously been utilized. 

The abuse of bank credit has long been a weak feature in 



! x8 CAPITAL 

modern business life, and will not quickly be eliminated. It 
may arise in two ways: either by making a wrong application 
of the funds secured from the bank, or by obtaining the funds 
on the strength of false or questionable claims. There are 
three legitimate reasons for making bank loans: first, to finance 
a temporary shortage of funds; second, to increase the stock 
of salable goods on hand; third, to extend additional credit 
to customers. The first reason may be quite acceptable, but 
only under exceptional circumstances. A firm, for instance, 
may have suffered a loss by fire and have insurance payments 
shortly due, in anticipation of which it may properly borrow 
from its bank ; or it may have funds shortly coming in from its 
stockholders or from other sources. Each case of this kind 
must be decided on its own merits. The second reason is 
the one that is customary and that is generally considered 
soundest. It is, of course, necessary for both the borrower 
and the bank to be reasonably certain that the goods being 
purchased are salable, so that there may be no question as to 
meeting the note out of the proceeds of the sale. The third 
reason is also concerned with the sale of goods, but this time 
from the standpoint of the seller. It is necessary here for 
both the borrower and the bank to make sure that the credit 
which is being extended to customers, is well placed and 
sound. 

If the borrower, instead of using the funds he receives 
from the bank for one of the three purposes above mentioned, 
utilizes it in extending his plant in the purchase of non-salable 
goods, in general advertising, or puts it into any other property 
or expenditure that is not readily convertible into cash, he 
may properly be said to be abusing the trust of his banker. 
More than that, he is seriously jeopardizing his own financial 
safety. "What difference does it make to the banker whether 
I use his money in one way or another?" is the answer of 
some business men, "sooner or later he will get his money 



BORROWED CAPITAL— SHORT-TERM 



II 9 



back with interest, and that's all he needs to fret about." 
Yes, but the banker is not in the business of making long-term 
loans or loans that may be sound enough but cannot be paid 
back on the dot. The only safe banking is short-term banking, 
and he is absolutely right when he insists that his loans be 
used only in quick turns and not for permanent or uncertain 
investments. 

The other abuse of bank credit is best illustrated by the 
great Claflin failure in New York in the summer of 19 14. 
On account of the high standing of the Claflin firm for gen- 
erations, and its unquestioned credit, it was permitted to dis- 
count many millions of dollars of paper issued by its sub- 
sidiary corporations. It was learned after the failure, that 
much of this paper did not represent actual commercial trans- 
actions. It was simply put out more or less at random when 
the firm needed money. The H. B. Claflin Company's con- 
tingent liabilities were never reported; in fact, no complete 
financial statements were given to bankers. In the absence of 
financial statements and of any definite form of assurance that 
single-name notes or notes issued by one subsidiary company 
to another subsidiary company in the same organization are 
representative of commercial transactions, there is really no 
method of telling whether a corporation is borrowing beyond 
the limits of safety or not. 

As is pointed out more fully on page 124, most banks are 
now beginning to insist quite properly on receiving financial 
statements. A committee of the New York Clearing House 
has suggested that a form of promissory note be devised, the 
signature to which certifies that the document is the product 
of a commercial transaction. The suggestion has merit, and 
with the strong backing of important banks behind it, might 
eventually be adopted. In this connection it might be well to 
say a word as to "accommodation" indorsements of commer- 
cial paper. This practice, which was formerly so prevalent 



I2 CAPITAL 

among individuals, is gradually dying away. There have been 
many instances of indorsers having suffered heavy losses 
simply because they were weak enough, or good-natured 
enough, to lend their credit to their acquaintances. Sometimes 
a corporation is guilty of lending its name in the same way, 
and with even less excuse. In fact, an indorsement by a cor- 
poration for accommodation is probably illegal, and would not 
be held good in most jurisdictions. A corporation is organized 
to carry on a certain line of business, for which it is granted 
definite powers under its charter. It is probably not within 
the legal power of any corporation to assume the responsibility 
which goes with an indorsement given without consideration. 

Bank Collateral 

We have spoken in the preceding section of bank credit 
as if it were always obtained on the strength of a firm's general 
standing. This is, in fact, the case when a concern borrows 
simply by giving its unsecured note, and even when it indorses 
and discounts a note which it has received from some customer 
who is practically unknown to the bank. Bank credit is even 
more extensively obtained, however, when it is directly backed 
by collateral security of some kind. Such loans are more 
easily granted, not only because the banker calculates that he 
is secured against loss, but also because he has a better check 
on the uses to which his money is to be put. 

Collateral may be conveniently classified under three 
heads : 

Stocks and Bonds 

Merchandise 

Bills and Accounts Receivable 

The first of these three classes is the banker's favorite, at 
least in the United States. This is due to the fact that stocks 
and bonds are usually salable, so that in case of default on the 



BORROWED CAPITAL— SHORT-TERM I2 i 

part of the borrower, the banker should have little difficulty in 
disposing of the collateral and repaying most or all of his 
advances. This statement is not to be taken as applying in- 
discriminately, to be sure, to all stocks and bonds; for the 
securities of some local or little known companies, even though 
the companies may be carrying on a successful business, are 
about as unmarketable property as can be mentioned. At the 
other extreme are the active securities of the great corpora- 
tions which are being daily bought and sold in large quantities 
on the New York and other stock exchanges; these are the 
securities that serve as collateral for the enormous amounts 
of call loans kept outstanding by the banks of the New York 
financial district. Between the two extremes there are many 
sound securities which the banker regards as at least fairly 
marketable, and which he is willing to take as collateral. Some 
of these securities are owned by commercial and manufactur- 
ing corporations which may properly use them as a basis for 
bank credit. There is, however, a limitation to be noted here. 
It is not regarded as sound practice for a corporation to post 
as collateral the stock of a subsidiary company. In the first 
place, the stock probably has no active market and the bank 
will accept it only reluctantly and when it is mixed with some 
salable collateral, and, in the second place, the corporation 
should not be compelled to take any chances — even remote 
chances — of losing control of an essential piece of property. 
The securities of subsidiary companies may serve properly as 
collateral for long-term bond issues, but not as collateral for 
bank loans. 

Merchandise serves as collateral when a company posts 
warehouse receipts, bills of lading, or specific liens upon 
specific pieces of its personal property as collateral. The first- 
named case is the one that is most common. Millions of dollars 
of holdings of cotton, wheat, and other grains are carried in 
this way every year following the harvesting of the crops. 



122 CAPITAL 

Once in a while manufacturing corporations may have col- 
lateral of this nature, as when a steel manufacturing company 
holds pig iron, but this is unusual. Bills of lading indorsed 
to the order of the bank commonly serve as collateral for 
drafts discounted by the seller of merchandise. Millions of 
dollars worth of grain, live stock, and other goods in transit 
are in this way utilized as backing for loans made by the banks, 
and accepted as collateral up to a fair proportion of their face 
value for direct bank loans. This is particularly true in the 
export trade where the banker does not feel sure enough of 
the standing of the drawer of the draft or of the salability 
of the merchandise to risk discounting the whole draft, but 
is willing to make advances up to, say, 50, 60, 80% or more 
of its face value. This is true also when the merchandise con- 
sists of goods that are perishable or that do not have a ready 
market. A draft covering a shipment of fruit, for instance, 
might not be readily discounted, but several of these drafts 
would be regarded as good collateral for an advance of say 
50 to 75% against their face value. Liens on specific pieces 
of personal property are not common, but may at times be 
perfectly good banking collateral. 

Accounts receivable fall into a different class. The evi- 
dence of indebtedness of a third party to the borrower is so 
uncertain and the claims upon specific property are so indirect, 
that accounts receivable are not customarily accepted as sound 
collateral for a bank loan. It is considered better for the 
company to borrow on its general credit rather than to assign 
its accounts receivable as collateral. Yet this customary rule 
appears to be based nearly as much upon prejudice as upon 
careful investigation. As a result of the unwillingness of most 
banks to accept assignments of accounts receivable as col- 
lateral, a considerable number of financing and discount houses 
have come into prominence during the last few years. These 
houses make a specialty of advancing money against open ac- 



BORROWED CAPITAL— SHORT-TERM ^3 

counts. It will be more convenient to discuss their methods 
and activities at some length a little later when we come to 
consider working capital. For the present, it is enough to 
note that during the sudden and severe crises produced in the 
United States in the fall of 19 14 by the outbreak of the 
European War, the influence of these discount houses was 
perceptibly increased. They customarily charge an interest of 
6%, plus a commission of 1 or 2%. They ordinarily allow 
interest to the customer on all items as fast as collected, and, 
inasmuch as they carry no deposits, they do not follow the 
banking custom of requiring that 20 to 2$ c /c of the proceeds 
of a loan remain on deposit without interest. They usually 
make advances up to about 80 to 85% of the face value of the 
receivables that have been assigned. The example of these 
discount houses has recently been followed, within moderate 
limitations, by some of the more progressive mercantile banks. 
The old prejudice against "hocking" accounts appears to be 
fading away. 

Factors Considered by Banks in Making Loans 

The underlying principles followed by the banker in ex- 
tending credit have been touched upon in the two preceding 
sections. It is important to bear in mind particularly, first, that 
the commercial banker must confine himself to making short- 
term loans; second, that he should satisfy himself that the 
money he loans is to be invested in such a way that it can 
readily be reconverted into cash; third, that credit granted 
on the general standing of a business enterprise entitles the 
banker to full and detailed knowledge of the inside workings 
of the enterprise; fourth, that collateral, to be acceptable, 
should consist either of securities and merchandise which are 
readily salable, or of drafts and accounts receivable which 
are quickly convertible into cash. 

Supplementing these four basic principles, there are some 



I2 4 CAPITAL 

observations to be made at this point as to factors which are 
taken into consideration by banks in making loans. First of 
all, attention should be directed to the growing custom of 
requiring detailed financial statements of customers to be filed 
from time to time. There was a time in this country not many 
years ago when a bank's request for such a statement was 
looked upon by the customer as in the nature of an affront 
or an impertinence. This is even yet the case in some sections 
of the United States, and is notably true in South America. 
However, this feeling is rapidly giving way to the saner idea 
that a bank is certainly entitled to reasonably accurate and full 
information as to any concern to which it is lending money, 
and that it is to the interest of conservative borrowers to 
comply with the bank's request for statements and thus put 
itself in a different class from non-conservative borrowers who 
are inclined to be secretive. The banks themselves are more 
and more inclined to insist not only on complete statements, 
but also on statements certified by public accountants. Such a 
suggestion is not intended as a reflection on the honesty or 
capability of the corporation's own accounting force; it simply 
brings to bear in addition the judgment of an unbiased per- 
son of wide experience who is in a far better position to 
value assets than any officer or employee of the corpora- 
tion. 

That banks are in favor of certified statements is plain 
from the answers received to a circular letter sent out in 
March, 19 14, by the American Association of Public Ac- 
countants, asking for bankers' opinions on this point. The 
844 replies were distributed as follows: 

Strongly in favor 121 

Favorable 501 

Opposed 15 

Strongly opposed 5 

Non-committal 202 



BORROWED CAPITAL— SHORT-TERM 



125 



Among the factors considered by banks in making loans, 
must necessarily be the legal restrictions in force or likely 
soon to be in force. The banking law which went into effect 
in 19 14 provides that, "any Federal Reserve Bank may dis- 
count notes, drafts, and bills of exchange arising out of actual 
commercial transactions." The effect of this law is to increase 
the value of two-name paper, accepted drafts, and other evi- 
dences of debt, which are the direct results of commercial 
transactions, and correspondingly to decrease somewhat the 
value of paper which is not available for rediscounting at 
Federal Reserve Banks. Under this law, the paper issued by 
one subsidiary company to a holding company as an accom- 
modation note — such as the 30 to 40 million dollars of Claflin 
notes previously referred to — would not be available for re- 
discounting. One result of the collapse of the Claflin firm 
was to strengthen greatly the movement in favor of putting 
a premium upon paper which arises out of commercial trans- 
actions. 

The Federal Reserve system also favors the policy of get- 
ting more written information than has heretofore been re- 
quired from customers in making applications for loans. Not 
only will paper based upon certified financial statements be 
favored in the rediscounting operations of the Federal Reserve 
Bank, but also there will probably be a strong tendency to 
insist that some evidence be given that bank loans are "self- 
liquidating" and that some assurance be extended that the 
loans are not to be used for permanent improvements to plants 
and the like. 

Among the unwritten rules that have long been customary 
among bankers in making loans, these two are of chief im- 
portance: First, at least 20 % of the bank loans should be 
retained as a deposit in the bank, the other 80% only being 
available for meeting obligations. This is a long standing 
custom, but is not universal. It is more strictly applied by 



l 2 6 CAPITAL 

some banks and in some lines of business than in others. 
Second, all bank loans should be "cleaned up" at least once a 
year so that the bank may make sure that the money it lends 
is not going into permanent investments. This is especially 
necessary in those lines of business which have well marked 
seasons of activity. It would be clearly inadvisable for a bank 
to allow a customer in such a line credit for the coming season 
until after he has paid up his loans for the previous season. 
With manufacturing corporations the rule is not so strictly 
applied; yet, even here it is properly thought to be desirable 
that the company's balance sheet should once in a while be 
wiped clear of bank loans. If this cannot be done, it is clear 
enough evidence that the company is using bank funds as a 
part of its permanent capital, and that it should be reinforced 
by the sale of more stock or long-term securities. 

All these rules of successful and conservative banking are 
also the rules of successful and conservative financing of all 
business corporations which borrow from banks. There is no 
conflict whatever between the two points of view. A banker 
wishes in normal times to lend as much as he can safely 
place; the treasurer of a borrowing corporation wishes to 
borrow as much as is consistent with safety. In theory there 
should never be a disagreement or a hitch between them. 
However, the frailties of human nature are not so easily set 
aside. A treasurer's prejudices and fancied interests fre- 
quently lead him to oppose reasonable requests and criticisms ; 
on the other hand, a banker is at least equally liable to suffer 
from obstinate prejudices. Recently an eastern manufacturer 
asked his banker for a loan of $25,000. "I see," said the 
banker looking over the manufacturer's statement, "that your 
advertising expense for last year just about equals $25,000. 
If you would cut off your advertising you would have all the 
money you need." The manufacturer tried to explain that it 
was necessary for him to advertise in order to sell his goods, 



BORROWED CAPITAL— SHORT-TERM l2 y 

and that the money borrowed from his bank was required in 
order to purchase raw materials which would be quickly manu- 
factured into salable articles. But the banker had a prejudice 
against advertising which nothing could shake.* The banker's 
work has a tendency to make him a slave to routine and to 
fixed ideas, which are obstacles to the prosperity both of his 
customers and of himself. 

Short-Term Notes Sold to the Public 

The exact line of division between notes delivered to note 
brokers and by them sold to banks, and notes delivered to 
private banking houses and sold to the general public may 
seem somewhat hazy. As a matter of fact, however, there 
is usually little difficulty in classifying a note as belonging in 
one or the other of these two groups. A note intended for 
sale to bankers is seldom more than 90 days and never more 
than six months, in length. A note intended for wider dis- 
tribution is customarily from one year to five years in length. 
As just indicated, the note brokers who handle the sale of 
the first class are entirely different from the stock and bond 
brokers and private banking firms that handle notes of the 
second class. 

Short-term notes for sale to the public may be legitimately 
issued for one of two purposes: either in anticipation of a 
later issue of long-term bonds or other securities, or in order 
to finance purchases or an improvement which is expected to 
produce so much new revenue that the note issue can be paid 
off at maturity out of the corporation's income. 

In order to facilitate the repayment, notes running for 
three to five years or longer are frequently issued in series; 
that is to say, an equal proportion of the note issue matures 
each year. They are in denominations ordinarily of $1,000, 



*See article on "Advertising as a Bankable Asset," bv Edward Mott Woolley, in 
Printer's Ink, October 15, 1914. 



I2 8 CAPITAL 

although they are sometimes as low as $500 or even $100, 
and they frequently go up to $10,000 or even $100,000. 

Short-term notes have been a feature of practically every 
financial crisis since the Civil War with the exception of 
1884. This has been due to the desire of established corpora- 
tions to avoid refunding of long-term bond issues which fall 
due during a crisis. This is certainly legitimate enough within 
proper limitations. In recent years, however, the habit of 
putting out note issues has grown even among the conserva- 
tive companies to such an extent that it is regarded as a real 
source of danger. 

Note issues have been utilized of late for almost every 
conceivable purpose for which long-time bonds used for- 
merly to be emitted ; for financing consolidations, to pro- 
cure cash in connection with liquidations, to effect 
segregation of corporations. Approximately $130,000,000 
in short-term notes were issued in Wall Street in 1903- 
1904 in connection with the "rich men's" panic of that 
winter. In 1907 they aggregated about $300,000,000; in 
1912, approximately $500,000,000; and over $550,000,000 
fell due in 1914.* 

Until recently, short-term note issues have been almost 
universally successful. The railroad notes have generally been 
refunded on maturity by bond issues. Their danger, however, 
is shown by the experience of the Erie Railroad Company in 
1908. This company had put out one-year notes in the middle 
of the crisis of 1907, which matured April 8, 1908. Four 
days before maturity J. P. Morgan and Company, as the rail- 
road's financial agents, published a notice to the effect that the 
notes would be refunded provided they were all deposited on 
or before April 8. As some of the notes were in Europe, 
compliance with this request was impossible. The 8th of April 
came. Some European notes were presented for payment and 

*See article on "A Rickety Practice in Finance," by William Z. Ripley, in New 
York Annalist, April 6, 1914. 



BORROWED CAPITAL— SHORT-TERM 



129 



it was announced that the money for their redemption was 
not at hand. To all appearances another bankruptcy was im- 
pending. Then suddenly E. H. Harriman, from his sick-bed, 
telephoned that he would take the whole burden upon himself. 
Immediately he arranged for a refunding issue of three-year 
notes and brought about a satisfactory redemption of the prev- 
ious issue. It was one of the most dramatic incidents in the his- 
tory of American finance. The occurrence serves to illustrate 
clearly the dangers that beset every corporation that relies too 
much on short-term notes which it cannot possibly hope to 
meet except by issuing other securities. As was remarked by 
Guy E. Tripp, chairman of the Westinghouse Electric Manu- 
facturing Company in 1914, "It is a bad thing to have a debt 
that you never intend to pay and never can pay; and that is 
what some short-term notes are." 

Aside from the danger, excessive financing through short- 
term notes is apt to become expensive. The interest payments 
may not be high, but every issue must be underwritten, and 
the underwriting commissions in a few years become a heavy 
burden. 

The highest grade short-term notes of large railroad and 
industrial corporations, ordinarily sell on a basis of 4% to 
S l /2%' A specialist in these notes said recently that he re- 
garded those yielding over 7% as the rankest kind of specula- 
tion, and "much more dangerous than active stocks which can 
generally be sold within one point of previous sales. A loss 
on a note when it comes, is like a fire loss; it is generally 
total." 

At the present writing, some securities of this type are 
being quoted to yield as high as 10, 12 and 15%. Some 
buyers of these high-yield notes have made a great deal of 
money on them, but they are to be regarded as dangerous 
in the extreme for any one who is not intimately acquainted 
with the issuing company. 



I3 o CAPITAL 

As the notes approach within six months or less of ma- 
turity, they come into an entirely different class, for they be- 
come available for the use of banks. Hence, they sell at prices 
which make their yield approximate the yield of commercial 
paper of the highest class. Sometimes the yield may be as 
low as iy 2 or 2%. 

A curious situation arises as a note comes very close to 
maturity, due to the fact that fluctuations of as little as even 
1/8 or 1/16 in the purchase price may make a considerable 
difference in the yield ; consequently, the tendency is for such 
notes nearing maturity to keep out of the market. 

Some short-term notes are secured by collateral ; others, as 
in the case of the Pennsylvania Railroad, rest solely upon the 
credit and reputation of the issuing company. Curiously 
enough, notes which command the best price and have the 
broadest market have no collateral behind them. The fact 
that collateral is posted is looked upon as indicating that the 
company has already used up all its unsecured credit. 

Professor Ripley has forced direct attention to what he 
well calls "the most deceptive practice" of carrying short- 
term notes in corporation balance sheets as a portion of funded 
debt instead of including them among the current liabilities. 
This has been true even of corporations of the standing of 
the Erie Railroad, and the Baltimore and Ohio Railroad. 
Notes running as long as 4 or 5 years are not, it is true, in 
exactly the same class as bank loans and accounts payable, 
most of which fall due within 30 to 90 days, but they are by 
no means a funded obligation. They must be met either out 
of income or by the issuance of long-term loans. They are 
properly offset and secured, as we shall see a little later, not 
by the permanent property and investments of the issuing 
corporations, but by the assets which are readily convertible 
into cash. 



/ 



CHAPTER VII 

BORROWED CAPITAL— LONG-TERM 

Bonds and Mortgages 

There is a fundamental difference — as will be emphasized 
from time to time in this volume — between short-term borrow- 
ing and long-term borrowing. While they tend in certain 
isolated cases to merge into each other, the distinction, as has 
already been pointed out, is for practical purposes clearly 
marked. 

The simplest form of long-term or "funded" borrowing is 
the ordinary mortgage on real estate or, as it is more correctly 
called, the bond and mortgage. The form of this instrument 
is almost as ancient as law itself. It purports to be a transfer 
of the title to a piece of real estate from the former owner 
to a new owner, with the proviso, however, that the title 
may be redeemed by the former owner by his repayment, at 
maturity, of an acknowledged debt which he obligates or 
"bonds" himself to repay. Although this is the immemorial 
form, the instrument does not, as a matter of practice and of 
legal interpretation, actually convey ownership of the property 
cited; its effect, in spite of the wording of the mortgage, is 
merely to pledge the property as security for the repayment of 
the loan. There are varying forms of the bond and mortgage 
in the different states which may not be covered in all their 
details by the description given above, but the essential char- 
acteristics of these bonds and mortgages are the same in all 
cases. 

The bond and mortgage is used ordinarily for relatively 
small amounts. It is the favorite form under which in- 
dividuals who own farms, city real estate, and other property, 

131 



I3 2 CAPITAL 

raise long-term loans secured by this property. It is fre- 
quently used also by smaller partnerships and corporations. 
But there are, of course, some obvious drawbacks to this form. 
In the first place, it is necessary for the mortgagor to find 
some one who is willing to invest the whole amount named in 
the bond in a lump sum. This may not be difficult so long 
as the sum is small. Mortgages are very commonly taken by 
savings banks and other institutions as well as by individuals 
who reside in the neighborhood of the property mortgaged 
and therefore are acquainted with it and at the same time 
are able and willing to advance the sum of money that is 
required. Within recent years there has been a concerted and 
successful effort to extend the market for farm mortgages, 
and a number of brokers operating in the agricultural states 
west of the Mississippi have built up successful businesses in 
selling mortgages direct to investors in the eastern states. 
Nevertheless the limitations make this a relatively inefficient 
and uneconomical method of raising funds.* 

The mortgagor of a piece of property may wish to borrow, 
let us say, $20,000. He finds three men, one of whom could 
lend $10,000, one $8,000, and the third, $2,000, but no one 
who is in position to lend $20,000. All insist on being pro- 
tected by a first mortgage. How is the difficulty to be solved? 
The answer is to be found in separating the bond and the 
mortgage. Let the mortgage be drawn in favor of some dis- 
interested party who will hold it, as trustee, for the lenders 
of the money. Let a bond, or promise to repay the sum ad- 
vanced, be given to each lender, the bond to be secured by 
the claim on the property which has been given to the trustee. 
By separating the bond and mortgage we have made it pos- 



*In most other countries where agriculture is highly developed there are 
"mortgage banks" which make it their business to receive and hold in trust mortgages 
of farm land and to issue their own bonds based upon these mortgages. It is thus 
possible to secure for farmers the same advantages that are treated in the next para- 
graph and that are now secured in the United States almost solely by large cor- 
porations. 



BORROWED CAPITAL— LONG-TERM 



133 



sible to secure the money that is needed from any number 
of different sources and yet have given the same protection to 
each lender that would be obtained by an individual who might 
advance the whole sum in a lump. 

Several years ago, for example, John Wanamaker, who 
was at that time individually the owner of his Philadelphia 
store, wished to borrow $10,000,000. It would have been a 
difficult thing to find one man or one institution that was 
willing to lend $10,000,000, but it was not especially difficult 
to give one mortgage for this sum, to issue 10,000 bonds each 
for $1,000, all equally secured by the mortgage, and to sell 
the bonds to investors. It is in this manner that the mortgage 
bond issues of corporations are created. 

Corporate Deeds of Trust 

The mortgage, separated from the bond, is more commonly 
known as a "deed of trust." In ordinary practice, the trustee 
who holds title to the property mortgaged and is supposed to 
act on behalf of the bondholders is a trust company. Or- 
dinarily, the trust company, however, is actually chosen, not 
by the bondholders, but by the corporation which issues the 
bonds. It is always expected at the outset that its duties will 
be of a purely formal character, and in the comparatively rare 
instances where it has been necessary for the trustee to take 
some active steps in order to protect the interests of the 
bondholders, there has been considerable complaint that its 
duties as a trustee were not performed with sufficient vigor. 
It would seem that some effective remedy for this complaint 
ought, if possible, to be found. The investment bankers of 
the country who have a moral responsibility in the matter, in 
that they sell corporate bonds in large quantities to the general 
public, might well consider the advisability of using their 
powerful influence to insure closer vigilance on the part of the 
trustees of large corporate mortgages. 



!34 CAPITAL 

The deed of trust for important bond issues is apt to be an 
extremely complicated and detailed document. To the lay 
reader its phrasing — like the phrasing of many other legal 
documents — appears cumbersome and unnecessarily redun- 
dant; but it must be borne in mind that thousands of cases 
have been adjudicated, each one of which has helped to inter- 
pret the exact shade of meaning of certain combinations of 
words. After the interpretation has once been made, it is 
safer by far to use that combination of words in the future, 
rather than to introduce new difficulties. As the result of long 
experience, corporate deeds of trust now tend to follow cus- 
tomary models and usually contain practically the following 
information: 

1. A preamble which sets forth the legal status of the 

corporation ; the amount of the bond issue and also 
of its other bond issues ; the authority given by the 
stockholders and directors for granting the mort- 
gage; the full text of the bond and other similar 
information. 

2. The granting clause which transfers the property to 

the trustee ; describes the duties of the trustee ; and 
contains the covenant of the corporation to pay 
principal and interest on the bond issue as due. 

3. The obligation of the corporation to maintain the 

property in good condition; to keep it insured; to 
pay taxes and the like. 

4. The procedure of the trustee in case of default. 

Usually there is no technical default until 30 days 
or more after a payment has become due. The 
percentage of bondholders — usually 20 to 25% — 
at whose request the trustee shall proceed to fore- 
close the mortgage or to take such steps as may be 
prescribed. 



BORROWED CAPITAL— LONG-TERM j^ 

5. The responsibilities, liabilities, and compensation of 
the trustee are presented, and provision is made for 
the resignation or removal of a trustee, and for the 
appointment of a successor. 

Many corporate mortgages contain what is known as the 
"after acquired property" clause, which makes the mortgage 
cover not only the specific pieces of property described therein, 
but also such other property as may later be acquired. The 
object clearly is to furnish further protection to the bond- 
holders and to make it difficult for the corporation to embark 
upon new expenditures without giving full protection to the 
bondholders. When this clause is missing, there is always 
the possible danger that the property covered by the mortgage 
may deteriorate or at least become of secondary importance as 
compared with other property later acquired. Suppose, for 
instance, that a manufacturing corporation mortgages one of 
its plants but later purchases another plant which is better 
located ; in that case the first plant would probably be neglected 
and would rapidly deteriorate. 

There is the opposite danger to the corporation in case 
the "after acquired property" clause is included in the mort- 
gage. The company may later wish to purchase property 
essential to its business and which will tend to increase the 
value of the property mortgaged. In order to purchase the 
new property, it will need to borrow more funds. But the 
"after acquired property" clause covers the new property with 
a first lien so that it may be impracticable to use it as security 
for the new loan. The usual solution of this particular prob- 
lem seems to be to evade the provisions of the mortgage by 
turning over the newly acquired property to a subsidiary cor- 
poration which is then able to give a first mortgage and go 
ahead with whatever borrowing is required. 

The question as to whether to include the "after acquired 



I3 6 CAPITAL 

property" clause or not, is clearly a choice between evils. There 
is no universal answer. The circumstances and probabilities 
in each case must be considered. This is a problem that would 
be more easily solved if the trustees of corporate mortgages 
were willing to assume a greater responsibility, in which case 
the bondholders would doubtless be willing to leave them a 
considerable amount of discretion. 

Another question in connection with most corporate mort- 
gages and bond issues, is whether they shall be "closed" or 
"open." They are "closed" when a given amount of bonds 
is at once issued under the mortgage, but no more may later 
be issued. The "open" mortgage, which is not customary 
except with railroad companies, leaves the total amount in- 
definite, although some restrictions are imposed. The most 
common arrangement is to permit the issue of bonds at a 
fixed rate per mile of track. The "closed" mortgage, like the 
"after acquired property" clause, may prove a serious hin- 
drance to the financing of new purchases which may be in every 
respect desirable. The "open" mortgage is subject to obvious 
abuses. In the practice of railroad corporations, a compromise 
has been found in recent years through the creation of what 
is known as "limited open end" mortgages, which authorize 
the ultimate issue of a much larger amount of bonds than it is 
intended to issue immediately. In this way, the future is 
provided for to a reasonable extent and yet the bondholders 
are protected from a reckless overissue which would danger- 
ously reduce the margin of safety back of their holdings. 

These "limited open end" mortgages may even cover bonds 
all of one issue but bearing different rates of interest. This 
has been the case with a number of railroad mortgage issues. 
Both the Chicago and Northwestern Railroad, and the 
Chicago, Milwaukee and St. Paul Railroad, have general mort- 
gages protecting some bonds that bear 3^2% and others that 
bear 4% interest. 



BORROWED CAPITAL— LONG-TERM 



137 



Corporate Bonds 

The larger an issue of corporate bonds — assuming of 
course that it is well secured — the greater will be the market- 
ability, and consequently the value of each bond. It is clear 
that a local corporation which puts out, let us say, one hundred 
$1,000 bonds, will be able to sell them only in its local market. 
The issue is too small either to become well known or to be 
easily salable at a moment's notice. The big bond issues, on 
the other hand, are being traded in all the time. It is for this 
reason that the tendency has been strong in the United States 
toward consolidating the various bond issues of the larger 
corporations into one issue, under a so-called "blanket" mort- 
gage, thus securing the important advantages of simplicity and 
of ready salability. $100,000,000 bond issues, which a few 
years ago were rare, are no longer regarded as uncommon. 
There are a number of much larger issues, the biggest of all 
being the recently authorized issue, amounting to $750,000,- 
000, of the Northern Pacific Railroad Company. 

In England this tendency toward large single issues is not 
nearly so apparent. On the contrary, English practice seems 
strongly to favor "hand to mouth", financing. Whenever 
money is needed, a separate security is planned and issued 
without much reference either to previous security issues or 
to the future. The result is that many of the English com- 
panies have a complex series of small bond issues, the relative 
claims and value of which can be determined only after com- 
petent study. The basic reason is doubtless to be found in 
the fact that the English investing public is more accustomed 
to buying and holding securities until their maturity so that 
there is relatively less trading in the open market than in this 
country. 

The great majority of bonds in the United States are in 
denomination of $1,000, although $500 is not uncommon. In 
recent years there has been a widely advertised tendency 



138 



CAPITAL 



toward the so-called "baby" bonds of $100 denomination. 
The chief argument for these bonds is that they make it pos- 
sible for a small investor, with perhaps only $1,000 to $5,000 
available, to diversify his investment just as is commonly 
done by large investors. This is an important benefit where 
its effect obviously is to reduce considerably the risk of heavy 
loss. The disadvantage lies in the increased cost of selling. 
It costs practically as much for a banker to sell a $100 bond 
as to sell a $1,000 bond, and his clerical expenses in connection 
with the transaction are fully as great. Unless he is operating 
on a larger margin of profit he does not find the small bond 
business very attractive. 

Bonds are frequently expressed in a currency different 
from that of the country in which they are issued. There are 
a great many Canadian bonds, for example, that are payable 
in pounds sterling, with a view to facilitating their sale in 
the London market. The Pennsylvania Railroad Company, 
the New York Central and Hudson River Railroad Company, 
and others, have issues that are payable in francs as well as 
in sterling. The Brazil Railways Company, an American 
corporation operating in South America, has a curious medley 
of issues payable in milreis (Brazilian currency), francs, 
pounds sterling, and dollars. Before the European War, a 
stronger and stronger tendency had been evident toward mak- 
ing the larger and more important issues international, and 
providing for their payment at fixed rates of exchange in the 
currency of any of the larger commercial countries, at the 
option of the holder. It is clear that this tendency has been 
checked. 

A great many bonds, especially those of an international 
character, are specifically payable in gold coin. This is a 
highly important provision in the countries in which there is 
fluctuation, or any considerable danger of fluctuation, in the 
value of the national currency. The European War, for in- 



BORROWED CAPITAL— LONG-TERM ^9 

stance, caused a sudden drop in the value of the currencies 
of Brazil, Chile, and other South American countries, which 
inflicted serious loss on many holders of securities payable 
in national currency. On the other hand, corporations suf- 
fered serious loss if they were unable to increase their receipts 
in national currency but at the same time had to pay their 
obligations in gold. This was one direct cause of the bank- 
ruptcy of some large enterprises. During the period of free 
silver agitation in the United States, prior to 1896, bonds 
which included the so-called "gold" clause, sold at a con- 
siderably better rate than those which were payable in Ameri- 
can currency, the value of which it was feared might de- 
preciate. 

The life of bond issues naturally varies a great deal, de- 
pending upon the prominence of the business and the nature 
of the assets offered as security. We shall have occasion to 
discuss this question with more detail in connection with the 
subject of methods of redemption of bonds. Some issues are 
perpetual. Among railroads, 100-year bonds have been fairly 
popular issues. Among those now outstanding which were 
put out for this period, are Lake Shore and Michigan first 
3^'s, issued in 1897; Norfolk and Western first consolidated 
4's, issued in 1896; Union Pacific, first and refunding 4's, 
issued in 1908; Manhattan Railway Elevated 4's, issued in 
1890; and Reading divisional mortgage issue of 1897. The 
Northern Pacific has one mortgage for 101 and another for 
150 years; the Erie Railroad has two mortgages at 91 years 
and one at 84 years. 

Interest is almost always paid semiannually. The favorite 
dates are probably January and July, although payments are 
scattered through the year. On account of the tendency which 
exists toward reinvesting interest and dividend disbursements 
in January and June, and the consequent tendency to increase 
stock-market prices at this time, there is theoretically a slight 



140 



CAPITAL 



advantage to the bondholder in getting his interest payments 
at other periods. This can hardly be called a consideration of 
much practical weight. 

We have already noted in speaking of stock certificates 
that bond certificates may be either in registered or coupon 
form. In American practice some bond issues are registered 
and some are in "bearer" or coupon form. It is becoming 
more and more the custom with large issues to give the owners 
of bonds a choice between the two forms. The registered 
form has the advantage of greater safety and the bearer, form 
the advantage of greater convenience. When the issuing cor- 
poration is located at considerable distance or an international 
market is desired, the bearer form is likely to be preferred. 
The favorite plan at the present time is to make bonds 
registered as to principal so that the transfer of the bond is not 
fully completed until it is made on the books of the corpora- 
tion, but to attach coupons covering the interest payments so 
that coupons — which are practically post-dated checks — may 
be clipped and deposited as they fall due. This has been 
demonstrated by long experience to be the simplest and most 
satisfactory method of collecting interest payments. 

It has been assumed so far in this chapter that bonds are 
always secured by mortgages covering real property. This 
is not, however, the case. There are three other important 
types of security: first, bonds, shares, or other securities may 
be posted as collateral ; second, a lien on chattel property such 
as locomotives, rolling stock, and the like may be accepted as 
security ; third, the general credit of a corporation may be the 
only security. 

We shall see plainly, in reviewing these various types of 
securities and their variations, that it is unsafe to place much 
dependence upon names. A "general mortgage" may not have 
a first lien upon anything; "first and refunding" or "first and 
unifying" and the like may indicate a first mortgage on some 



BORROWED CAPITAI^LONG-TERM 



141 



small subdivisions of the property and a second, third, or 
fourth mortgage on the rest of the property. Every bond 
issue stands by itself and has its own peculiarities. It is un- 
safe to comment upon it — and it is certainly unsafe in the 
extreme to buy it — without having first studied with some 
care the exact terms and extent of its claim upon property and 
the nature and value of the property itself. 

Mortgage Bonds 

Bonds that are backed by a mortgage on real property are, 
in this country, the most popular type of bonds and will 
probably always remain so. In the United Kingdom it is 
customary to issue debenture bonds (having no specific secur- 
ity behind them) in many cases where we issue mortgage 
bonds. The difference is in name rather than in fact, for 
the English debenture bonds are considered by the investor 
with at least partial reference to the amount and the nature of 
the corporation's holdings of real property. 

After all, the great bulk of the wealth of this country is 
in the form of real estate. The greater the increase of other 
forms of wealth, the greater must be, necessarily, the increase 
in land values. Hence, a mortgage on land, assuming that it 
is conservatively placed, is bound to remain the most common 
and perhaps the safest form of security. This is not to say, 
by any means, that every mortgage bond is safe, but only to 
state the general principle that land and other real property 
constitute the most acceptable form of security for bond 
issues. 

Not only is a promise to pay secured by real estate the 
most popular type of secured obligation, but, for most in- 
dividually owned businesses, partnerships, and small corpora- 
tions, it is in fact the only practical form of long-term obliga- 
tion. Other forms of security are utilized in the main only 
by large concerns which are widely and favorably known and 



142 



CAPITAL 



therefore enjoy an exceptional measure of credit apart from 
their property holdings. 

The great mass of obligations on real property are secured 
by first mortgages. There is a considerable amount, also, of 
second mortgage securities and relatively few third and fourth 
mortgage securities. Third and fourth mortgages are seldom 
found except among the obligations of large railroad corpora- 
tions. The Northern Pacific put out a third mortgage issue 
of $12,000,000 in 1887; the Erie Railroad has outstanding 
third, fourth, and fifth mortgage bonds. Modern practice 
favors disguising these junior issues by some euphemistic 
name. For instance, at the reorganization of the Erie Rail- 
road in 1895 when a sixth mortgage issue was found to be 
necessary, it was not called a "sixth mortgage" but "Erie 
Railroad First Consolidated Mortgage 7's, 1920." This title 
does not mean, as the unsophisticated might imagine, that the 
issue is protected by a first mortgage, but only by a "first con- 
solidated mortgage'' whatever that may be. A little later we 
have the "First Consolidated 4/s, 1996," which receive the 
title of "first" apparently because, though not the first con- 
solidated issue of the road, they are the first consolidated issue 
to bear interest at the rate of 4%. Finally, the Erie put out 
what is practically an eighth mortgage, which was christened 
"General Mortgage Convertible 4's, 1953."* 

The Erie is a shining, but by no means isolated, example. 
It would not be difficult to bring to light many another fourth, 
fifth, sixth, or even later mortgage which is masquerading as a 
"first refunding" or "prior lien" or under some other high- 
sounding name. 

A second mortgage issue, when it is recognized as such, 
will customarily have to pay a rate of interest J4 to 1% higher 
than a first mortgage issue, and will customarily, also, be 
redeemable within a shorter period. The issues which are 

•See W. H. Lyon's "Capitalization," pp. 118-121. 



BORROWED CAPITAL— LONG-TERM j^ 

protected by subsequent mortgages may be expected ordinarily 
to pay still higher interest rates in rough proportion to the 
priority of their claims. However, this is not stated as an 
invariable rule, for in many cases the junior mortgage issues 
are of larger size and enjoy a wider market or have the other 
advantages which more than compensate for the inferiority 
of their liens. 

Ratio of Mortgage to Value 

The question as to the correct percentage of obligations 
secured by mortgage to the appraised value of the mortgaged 
property is one of much practical interest. There are many 
surprising variations in practice. Roughly speaking, it may 
be said that the highest grade issues, secured by a mortgage on 
land, do not exceed 50 to 60% of the appraised value of the 
land. The highly regarded "cedulas," for example, issued by 
the National Mortgage Bank of the Argentine Republic, never 
exceed 50% of the appraised value of the mortgaged land. 
In ordinary practice, a second mortgage on land should not 
bring the total mortgage issues above 80% of its value. A 
mortgage based in part on buildings and other improvements 
which may not be easily adapted to other uses, and are not so 
readily salable as land alone, cannot safely run to as high a 
percentage of the appraised value. 

The percentages that have just been given are intended to 
represent an ideal — or at any rate, the most exacting standards 
— rather than ordinary commercial practice. The following 
examples picked at random from the reports of many different 
companies operating in various fields and carrying on various 
kinds of business, show provisions that have been found ac- 
ceptable by some of the good banking houses: 

The Montreal Light, Heat and Power Company has per- 
mission to issue 43^2% first mortgage bonds, to pay for im- 
provement up to 75% of the cost of the improvements. 



I4 4 CAPITAL 

The Mississippi River Power Company can issue bonds in 
excess of $16,000,000 under its first mortgage, up to 80% of 
the cost of improvements. 

The Powell River Company, which produces water-power, 
manufactures paper, etc., can issue additional bonds under 
its first mortgage up to not more than 50% of the actual cost 
of permanent extensions, additions, improvements, or ac- 
quisitions. 

The Steel Company of Canada, Ltd., may issue additional 
bonds to the extent of 66 2/3% of the proposed value of new 
fixed assets. 

The Taylor- Wharton Iron and Steel Company may issue 
its first mortgage 5's beyond $1,250,000 for permanent im- 
provements up to 75% of their cost. 

The American Ice Company may issue the balance of its 
real estate first and general sinking fund gold 6's, for improve- 
ments up to 75% of the cost. 

The United States Lumber and Cotton Company can issue 
additional bonds to the extent of 50% of the cost of better- 
ments. 

The American Sales Book Company, Ltd., may put out 
the balance of its first sinking fund 6's, up to 80% of the 
cost of extensions. 

Both the New York and Cuba Mail Steamship Company 
and the New York and Porto Rico Steamship Company are 
permitted to issue additional first 5's for 80% of the actual 
cost of new property. 

The General Baking Company, incorporated in 191 1, a 
combination of twenty large baking establishments in various 
large eastern cities, is permitted to issue the balance of its 
authorized first mortgage bonds to the extent of 70% of the 
cost of permanent betterments, improvements, developments, 
extensions, and additions, except for the purchase of stocks 
of other companies. 



BORROWED CAPITAL— LONG-TERM 



145 



The General Pipe Line Company may issue bonds to pro- 
vide 80% of the actual cost of acquisitions, additions, etc. 

The International Milling Company of Minnesota may 
issue bonds up to 75% of the actual cost of the establishment 
of additional mills. 

The Iroquois Iron Company may issue first gold 5's up to 
60% of the cost of additions and extensions. 

The Chicago Bell Telephone Company restricts its first 
mortgage issue to 50% of the value of its property or 60% 
of the value of its real estate; it may issue further bonds not 
to exceed 75% of the cost of additional improvements and 
extensions. 

The Nashville Railway and Light Company may issue its 
authorized bonds up to 80% of the cost of improvements. 

In general, manufacturing companies are supposed to pre- 
serve a margin of safety of at least 25% between the cost 
of improvements and the amount of bonds issued to finance 
these improvements. This margin may be reduced to 20% 
in the case of companies that have a very stable business, or 
may be increased to as much as 40 or 50% for companies that 
do not claim any especial degree of stability in their earnings. 

Equipment Trust Bonds 

When a dealer sells a piano on the instalment plan, he 
does not ordinarily give his customer at once full title to the 
piano; instead he "leases" it at a rental equal to the amount 
of the instalment payments agreed upon, with a further agree- 
ment that as soon as the payments under the lease equal the 
agreed price for the piano, then these payments shall cease and 
full title shall pass to the customer. By this simple device he 
protects himself in part against an unscrupulous purchaser 
who might, if he had full title, dispose of the piano, spend 
the cash that he received in payment, and leave the dealer only 
the doubtful privilege of suing him for fulfilment of his con- 



146 



CAPITAL 



tract. Under the "lease" arrangement, the customer has no 
right to resell the piano until his own payments have been 
fully completed. It is, of course, recognized that a "lease" 
of this kind is essentially a legal fiction — just as the mortgage 
which conveys the title to the lender of money is a legal fic- 
tion. Nevertheless it is a fiction which is useful and indeed 
indispensable. 

When a manufacturer of railroad equipment sells an order 
of millions of dollars' worth of cars or locomotives to a rail- 
road, he protects himself in the same way. The title is retained 
in his own hands ; the railroad merely "leases" the rolling stock 
with an agreement that on completion of the payment of a 
certain amount, the "lease" shall become inoperative and the 
title will be taken by the railroad. Thus the railroad com- 
pany — just like the individual who buys his piano on the in- 
stalment plan — is unable to dispose of the cars. A point of 
greater practical importance is that, in case of receivership 
or financial embarrassment, the seller of the cars or locomo- 
tives can take them back if he chooses; they belong to him, 
not to the railroad. 

There are some variations of this procedure but they do 
not affect its principle. The chief variation consists in the 
introduction of a financing company between the manufacturer 
of railroad equipment and the railroad company which pur- 
chases the equipment. The financing company takes upon 
itself the burden of paying the manufacturer, and receives title 
to the cars or locomotives. This title it may offer as security 
for an issue of equipment trust obligations in the form of bonds 
or notes.* 

Equipment bonds enjoy an excellent reputation for safety; 
in fact, it is claimed that there has been no default on them 
since they have been in use. Even though a railroad may go 

*These equipment trust obligations may be called either bonds or notes almost 
indiscriminately; as they generally run for 10 or 15 years, it is perhaps a little better 
to speak of them as "bonds." 



BORROWED CAPITAL— LONG-TERM ! 47 

into receivers' hands and become almost a total financial wreck, 
it cannot afford under any conditions to give up its rolling 
stock, and must therefore maintain its annual payments. For 
this reason it happens that the equipment trust bonds, even 
of railroads that are actually in receivership and that have 
defaulted on practically all of their other obligations, fre- 
quently sell on a basis of 5 to 6 l / 2 %. The equipment trust 
bonds of sound railroad corporations are in great demand 
and sell customarily on a basis of 4 to 5%. 

It has been at times suggested that the same principle 
might be more widely applied, as for instance in selling ma- 
chinery and other essential equipment to manufacturing cor- 
porations. The difficulty, however, arises that outside the rail- 
road field, transactions which could be financed by equipment 
trust obligations are of comparatively small size, and could 
not easily be standardized in such a way as to make them 
appeal to the investing public. The average investor, even 
though he may be a bank official and well acquainted with 
financial practice, does not care to spend much time in analyz- 
ing and investigating propositions that are put up to him when 
he goes into the market to buy a security. He wants to get 
something that is standardized and familiar. It is only after 
years of active effort that a new financial method ordinarily 
can be introduced. For this very reason there is, perhaps, a 
real opportunity which some one will sooner or later seize, to 
apply the equipment trust method more widely and thus 
facilitate the sale of many kinds of machinery, 

Collateral Trust Bonds 

The use of marketable stocks and bonds as collateral for 
short-time loans has already been noticed in the chapter pre- 
ceding. The issue of long-term obligations based on similar 
security is, however, comparatively a modern invention. There 
is a fundamental distinction between the two. 



148 



CAPITAL 



Short-term obligations are ordinarily secured by stocks 
and bonds which are active and which the borrower holds 
temporarily for resale. Long-term bonds should never be 
secured except by stocks and bonds that it is intended to hold 
permanently. Ordinarily these securities, posted as collateral, 
are those of subsidiary corporations or of other corporations 
in which the borrowing company expects to maintain a per- 
manent interest. Sometimes nearly all the stocks and bonds 
of subsidiary companies, held in the treasury of the parent 
company, are collected and posted in one lot. This is the 
case, for instance, with the Missouri Pacific $10,000,000 issue 
of collateral trust bonds which is secured by the deposit of 
first mortgage bonds of subsidiary companies. Twenty of 
these companies are represented, one of which is operating a 
road only two miles long. 

It is a somewhat curious fact that a collateral trust issue 
will generally sell at a much better price than will the stocks 
and bonds which are posted as collateral. The reason is to 
be found not only in the fact that the parent company is add- 
ing its quota of credit to the credit standing of its various 
subsidiaries, but also in the fact that the collateral trust issue 
is comparatively large and therefore commands more atten- 
tion and a better market. Inasmuch as the amount and quality 
of the collateral posted is seldom examined with much care 
by investors, there is always a chance, unless the banking 
syndicate which sells the issue is very careful, that the col- 
lateral will eventually be found of less value than was origin- 
ally supposed. The general public, in fact, has no method, 
ordinarily, of securing genuine information as to the status 
and prospects of subsidiary companies whose securities are 
posted. It must regretfully be admitted that the collateral 
trust device has sometimes been used to obtain credit for cor- 
porations that were not worthy of credit. 

A collateral trust bond issue is the favorite method of 



BORROWED CAPITAL-LONG-TERM I49 

financing the purchase by one corporation of the securities of 
another corporation. The purchase may be made in the first 
place with temporary bank loans, which in their turn are 
repaid as soon as the collateral trust bonds can be sold to 
the investing public. It was in this way, for instance, that 
the Northern Pacific and Great Northern financed their pur- 
chase of stock of the Chicago, Burlington and Quincy Rail- 
road Company. The collateral trust bond issue based upon 
this stock is highly regarded. In the same way the Atlantic 
Coast Line took care of the purchase of Louisville and Nash- 
ville stock, and the Union Pacific of the purchase of Southern 
Pacific, of Baltimore and Ohio and of New York Central 
stock. 

While the collateral trust bond issue is used most exten- 
sively by railroad corporations, it is common also among 
public utility holding companies and is used to a less extent 
by industrial combinations. The customary rule is to make 
the collateral trust bond issue about 80% of the appraised 
market value of the securities posted as collateral. This is 
the same percentage that is commonly regarded as proper 
among banks in granting short-term collateral loans. How- 
ever, there are some exceptions. For example, the Oueens- 
boro Corporation, which deals in New York City real estate, 
has outstanding an issue of first gold 4's, secured by a deposit 
of mortgages on New York City real estate to an amount at 
least equal to the bond issue. 

Debenture Bonds 

A debenture — to give its literal and also its technical legal 
meaning — may be defined as any acknowledgment of debt 
which, of course, implies a promise to repay the debt. In 
financial practice, however, the word has gradually become 
restricted until it now means only an unsecured promise to 
repay a debt. In England a distinction is made between de- 



IS© 



CAPITAL 



benture bonds, generally called simply "debentures," and de- 
benture stock ; debenture bonds are in fixed amounts ( say £20, 
f 100, £200, £1,000, etc.), while debenture stock may be trans- 
ferred in any amount that may happen to suit the convenience 
of buyer and seller. Under English practice a man may hold 
debenture stock in an amount, let us say, of £1263 6s. 3d., and 
may sell, let us say £563 4s. 2d. ; while of debenture bonds 
his holdings and his sales must be in fixed amounts depending 
on the conditions of issue. Thus it will be seen that in England 
the distinction between debenture bonds and debenture stock is 
much the same as between ordinary shares and ordinary 
stock. 

The English practice and American practice in the use that 
is made of debentures is entirely different. In English prac- 
tice the mortgage bond is not so nearly universal as in this 
country, and the debenture bond or stock takes its place. We 
may draw a loose distinction between the two systems by 
saying that the American practice favors the issuance of obli- 
gations which are primarily protected as to their principal by 
the issuing company's assets, and as to their interest claims 
by the issuing company's income; while in English practice, 
the bondholder is protected primarily as to his interest by the 
priority of his claim on the issuing company's income, and is 
protected as to his principal only by the general credit of 
the issuing company. There has been some little debate at 
different times as to the relative merits of the two systems. 
The American system is criticized on the ground that, after 
all, the only test of the value of a company's assets is the 
amount of income they yield, and the English system, there- 
fore, is not only simpler but more logical. On the other hand, 
it is stated that, in case the English debenture holder fails to 
receive his interest payments regularly, he has no further 
claim on which he can fall back. Hartley Withers, a leading 
English authority, asserts that "mortgage rights, carrying with 



BORROWED CAPITAL— LONG-TERM l $ r 

them the power of foreclosure, are always desirable to com- 
plete the security of the debenture holder The absence 

of mortgage rights is a weakness in an otherwise watertight 
security/'* 

The debate is of little more than academic interest, for the 
practice of each country is firmly established and is unlikely 
to be changed by any argument. 

In the United States, debenture bonds are quite commonly 
used in railroad reorganizations, in the general scaling down 
of claims upon the assets and income of the corporation. 
There will be references to some such cases in connection 
with the later study in this volume of reorganization practice. 
In other cases, debentures have been issued by American cor- 
porations in high credit, simply because they preferred the 
simplicity of the debenture form, and were able by reason of 
their general credit to sell them on a satisfactory basis. This 
has been true in the past, particularly of the New England 
railroads, the New York, New Haven and Hartford, and the 
Boston and Maine. 

Still another case that calls for debenture bonds exists 
when a small corporation which has a relatively small amount 
of tangible assets, but possesses good- will and other intangible 
assets of high value, desires to make a long-term loan. Inas- 
much as a corporation of this type does not have the proper 
basis for either a mortgage bond issue or a collateral trust 
bond issue, it is likely to fall back on a debenture bond issue. 
This is especially true, for example, of publishing companies, 
many of which are well established and can conservatively put 
out a long-term loan and yet possess tangible assets of com- 
paratively small and uncertain value. Following is a form of 
debenture bond which has recently been used by a small com- 
pany of this type, and which is suitable for use in similar 
cases: 



'Hartley Withers on "Stocks and Shares," p. 96. 



152 



CAPITAL 

Twenty-year Six Per Cent Debenture 

The Company, a Corporation of the 

State of New York (hereinafter called the Company) is 
indebted and for value received promises to pay to the 
registered holder, the sum of 

One Thousand Dollars 
in lawful money of the United States, on or before 
August 15, 1931, and interest semiannually on said sum, 
at the office of the Company in the City of New York, 
at the rate of six per cent per annum, on August 15 and 
February 15 in each year. Such interest shall be cumu- 
lative and payable in priority to any dividends on the 
stock of the Company for such half-yearly period. 

This Debenture is one of a series of 47 debentures, 
all of even date, 27 being for the principal sum of 
$1,000 each; three for the principal sum of $500 each; 
13 for the principal sum of $100 each, and 4 for the prin- 
cipal sum of $50 each, a total of $30,000. 

This Debenture shall immediately become due and 
payable if a judgment or decree is rendered for the disso- 
lution of the Company by any court having jurisdiction 
thereof, or if the Company is adjudicated a bankrupt or 
insolvent, or if an effective resolution is passed by the 
stockholders for the voluntary dissolution of the 
Company. 

This Debenture may be redeemed by the Company at 
any time at its face value, and interest earned and unpaid 
hereon, upon thirty days' notice in writing sent by mail 
or delivered personally to the registered holder hereof. 

A Register of the debentures shall be kept at the 
Company's principal office containing the names and 
addresses of the registered holders and particulars of 
the debentures by them respectively. 

Every Transfer of this debenture must be in writing, 
signed by the registered holder, or his legal personal 
representative, and shall be delivered at the Company's 
principal office, and duly acknowledged, if required by the 
Company, and thereupon the transfer will be registered 
and a note of such registration entered hereon. 



BORROWED CAPITAL— LONG-TERM 153 

In Witness Whereof the Company has caused this 
instrument to be signed in its name and behalf by its 
President, and its corporate seal to be hereunto affixed 
and attested by its Secretary, this nth day of August, 
1911. 

Company 

By 

President 
Attest : 



Secretary 

It is quite possible that, in many instances where small 
corporations are now borrowing up to the limit of safety 
at a bank and yet are cramped for funds, a small issue of 
debenture bonds could be marketed among people who are 
acquainted with the corporation and recognize its solidity. 

Some debenture bonds, although not secured by the pledge 
of specific properties, are protected by especial provisions 
which may give them an advantage over holders of wholly 
unsecured and unprotected obligations in case of reorganiza- 
tion. For instance, the American Cotton Oil Company has 
outstanding an issue of debenture bonds the principal of which 
may at once become due, in case there is a default in payment 
of interest, at the option of a majority of the holders of the 
bonds. The American Tobacco Company's gold debenture 
6's and 4's are not secured by Hen or mortgage on properties, 
but a charge is imposed in favor of the trustees acting for 
the debenture bondholders, upon the property and upon all 
the present and future net incomes of the corporation. This 
gives the owners of these debentures an advantage over the 
owners of any subsequent debentures or obligations that the 
company may incur. 

There are one or two curious instances of so-called deben- 
ture bonds issued in this country and in Canada, which are 
not, in fact, debentures at all, but possess what is here consid- 



154 



CAPITAL 



ered a preferable mortgage security. For example, the Cana- 
dian Niagara Power Company has outstanding an issue of 6% 
debentures, series "A" and "B" of which are secured by a 
first mortgage, and series "C" by a second mortgage. The 
Wabash Railroad Company has a third mortgage issue out- 
standing which is called "Debenture Bond Series 'A.' ' Some 
of the Chicago and Great Western debentures, also, are really 
mortgage bonds. As has been remarked before, it is unsafe 
to place any reliance upon names unless they are used in a 
strictly legal sense. The use of the term "debenture" in all 
these companies is doubtless in order to facilitate the sale of 
the bonds in the English market. 

Income Bonds 

Income bonds may be briefly described as almost the exact 
opposite of debentures. The debenture has primarily a claim 
on income, with little or no specific security for the repay- 
ment of the principal. The income bond is usually secured 
as to its principal by a mortgage lien of some kind, but has 
no claim for interest payments except as and when the issuing 
corporation has a surplus of earnings over and above all prior 
claims. The income bond is a hybrid and frequently possesses 
few of the attractive features either of ordinary bonds or 
of stock. It is seldom accepted by investors from choice. Most 
of the issues of income bonds now outstanding are the 
products of reorganization. In the general scaling down of 
creditors' claims which attends every successful reorganization, 
some of the bondholders are likely to be required to give up 
their claim to a fixed income, and to accept the claim which 
is possessed by the income bond to a fixed income only when 
it is earned. 

Theoretically, this arrangement is fair enough and offers 
junior bondholders of an insolvent corporation all that they 
can reasonably expect to obtain, When income bonds were 



BORROWED CAPITAL— LONG-TERM T ^ 

first issued extensively in the United States, during the numer- 
ous railroad reorganizations of the 8o's, they were generally 
regarded as an ingenious and praiseworthy device, but later 
experience has not confirmed this favorable first impression. 
Difficulties continually arise out of the fact that the determina- 
tion of net earnings in a large corporation is not a purely 
mathematical process, but involves much discretion and con- 
tinually gives rise to differences of opinion. It is to the interest 
of the common stockholders, who usually have control of the 
corporation, to defer payments to income bondholders as long 
as possible, or until the time arrives when dividends may be 
distributed also to the stockholders. It is easy enough for them 
to prevent payment of interest on income bonds if they so 
desire, by instructing the auditor to charge many expenditures 
of a capital nature into operating expenses, thus reducing the 
nominal showing of net earnings. 

The best-known case of this kind is that of the Central of 
Georgia Railway Company, which issued in its reorganization 
of 1895, three series of income bonds, all falling due in 1945. 
For several years the holders of income bonds, to whom no pay- 
ments were made, protested that they were not receiving fair 
treatment. Finally, in 1913, after long litigation, an auditor 
was appointed by the court and found that the Ocean Steam- 
ship Company, all of the stock of which was owned by the 
Central of Georgia Railway Company, had been earning large 
profits which were never taken into the published accounts of 
the Central of Georgia Railway Company. The earnings of 
the Ocean Steamship Company were turned over to the parent 
corporation under the fiction of a "loan" which was never in- 
tended to be repaid. Counsel for the Railway Company did 
not deny the facts but argued on the strictly technical ground 
that so long as dividends had not been declared by the directors 
of the Ocean Steamship Company, it was impossible to include 
these earnings in the income account of the Central of Georgia 



156 



CAPITAL 



Railway Company. It is a relief to find that the court dis- 
regarded this shallow pretext and took the common-sense view 
that the earnings of the Central of Georgia Railway included 
the earnings of its subsidiary company. In this instance the 
income bondholders finally won their case and are now receiv- 
ing payments of interest. It was, however, a long and hard 
battle which offers little encouragement to investors to put 
their money into securities of this type. It has been well 
remarked in this connection that "the income bondholder 
may find that he has purchased a lawsuit rather than a 
security."* 

Sometimes the holders of income bonds are given some 
of the rights of stockholders. The income bondholders of 
the New York Railways Company, which owns a number of 
the surface street railway lines in New York City, have the 
right to elect five out of eleven directors of that company. In 
the latter part of 19 14, an active campaign to secure the 
proxies of income bondholders was conducted by the presi- 
dent of the New York Life Insurance Company, with the co- 
operation of other investors. It was announced that this cam- 
paign was based on the belief that the bonds were entitled to 
more interest than they had been receiving and that it was 
desired to elect directors who took the same view. "It should 
be remembered," it was stated, "that these bonds are not cumu- 
lative, and any income to which they are fairly entitled not 
currently received is utterly lost, unless the court shall decide 
to order a new accounting from the date of reorganization. A 
suit calling for such action is now pending." 

That holders of income bonds may sometimes have to 
content themselves for a long period without obtaining either 
income or a return of any of their principal is clear from the 
report of the Comstock Tunnel Company. This company has 
outstanding $2,769,000 first income 4/s, on which no interest 

*Lyon on "Capitalization," p. 40. 



BORROWED CAPITAL— LONG-TERM 



157 



has been paid since 1892. An extraordinarily weak claim is 
that of the Reading deferred income bonds, which are not 
entitled to interest until after the common stock has received 
6% dividends. 

Although new issues of income bonds have been rare in 
recent years, the Hudson and Manhattan Company put out 
in 1 91 3 a series of contingent income bonds. In industrial 
corporations they are rarely to be found. Out of 40 or more 
industrial security issues discussed in Dewing's "Corporate 
Promotions and Reorganizations/' only two are income bonds, 
those of the Mount Vernon-Woodberry Company and the 
Standard Rope and Twine Company. The Mount Vernon- 
Woodberry bonds were secured by a second mortgage on all 
the fixed assets and a direct lien on all the merchandise and 
quick assets. They proved a constant source of controversy 
and greatly handicapped the company in securing short-term 
bank credit which is especially essential in textile manufac- 
turing. The indenture of these income bonds was faulty in 
that it made no provision for allowing depreciation before 
figuring net earnings, thus giving rise to many impossible 
demands on the part of the dissatisfied income bond- 
holders.* 

Income bonds and stock are used to a limited extent also 
in English practice. The same objections, however, have 
arisen there as in this country, and the tendency is in favor of 
other securities which give less room for misunderstanding 
and controversy. The Lancashire Power Construction Com- 
pany, Ltd., has outstanding an issue of income stock which was 
issued as a bonus to subscribers to debenture stock. The in- 
come stock is entitled to 75% of the net profits after deducting 
interest on bonds and debentures, and the principal is repay- 
able, in case the company is wound up, after prior debts have 
been liquidated. 

*Dewing's "Corporate Promotions and Reorganizations," r,p. 340, 363, 606. 



158 CAPITAL 

Convertible and Participating Bonds 

Most purchasers of the bonds of high grade companies are 
primarily interested in the safety of their principal plus a 
moderate rate of return. Most purchasers of shares, on the 
other hand, are primarily interested in securing profits due 
to the enhancement of the value of their holdings, plus as 
high a rate of return as they can secure. If they purchase 
stock with their eyes open, they realize that they are volun- 
tarily incurring more or less risk. Between these two main 
bodies of purchasers of corporate securities, there are a great 
many investors who wish to secure reasonable safety com- 
bined with a reasonable chance for appreciation in the value 
of their holdings. Preferred shares are intended in part to 
meet the wishes of this intermediate class. Convertible and 
participating bonds are designed also to appeal to this group. 

The adjective "convertible" in itself has no definite mean- 
ing. The bonds may be convertible into anything on any 
terms. Ordinarily, however, the convertible feature gives to 
bondholders the privilege of exchanging their bonds within 
certain time limits and at a rate fixed in advance, for the 
corporation's common shares. The bondholder may reason 
that he secures under this arrangement a sound and safe se- 
curity which yields a moderate rate of return and in addition 
has a chance of speculative profits due to the possible enhance- 
ment in the value of the company's shares. Thus, the Union 
Pacific Railroad Company's issue in 1901, of $100,000,000 
of 4% bonds, which were convertible into common stock at 
par before the expiration of this conversion privilege, sold 
considerably higher than par. Practically all of this issue was 
converted and its holders obtained a sizable profit. It has not 
been unknown for original purchasers of these securities to 
obtain profits in this manner running as high as 25 to 50% ; 
this is in addition to the normal rate of interest on their 
investment. 



BORROWED CAPITAL-LONG-TERM l59 

There is, of course, the corresponding drawback that the 
conversion privilege, if it is really valuable, increases the sell- 
ing price of the bonds and this lowers slightly the yield on the 
investor's capital. However, in view of the fact that the 
large buyers of bond issues are institutions which are not at- 
tracted by the possibility of speculative profits, it has been 
found that those who were willing to purchase the convertible 
bonds of good companies are frequently able to get them at 
a very reasonable price. There are, of course, all shades of 
variations in the attractiveness of convertible bonds. The 
Pennsylvania Railroad Company has put out some issues which 
are convertible into common stock at such a high rate of ex- 
change that there seems to be no probability that the conversion 
privilege will become valuable. 

From the corporation's point of view there are obvious 
objections. It may well be argued that the company is taking 
the chances. If its business moves along successfully and its 
stock increases in value, the holders of convertible bonds share 
in the prosperity without having shared in the preliminary 
risks. On the other hand, in case some unforeseen misfortune 
reduces the company's earnings, the convertible bondholder 
naturally enforces his claim with the same rigor as any other 
creditor. As a matter of fact, convertible bonds are seldom 
issued except in periods when the demand for capital is large 
and when it is necessary for corporations — even those in 
highest standing — to make concessions. In the United States, 
these securities were first issued during and after the Civil 
War. The financing of the Chicago, Milwaukee and St. Paul 
Railroad Company from i860 to 1880 was chiefly effected 
through issues of convertible bonds, and it is stated that as 
late as 1896 there were twelve separate convertible issues of 
this company outstanding. From 1880 to 1900, on the other 
hand, the practice was discontinued and was generally thought 
to have become obsolete. Since 1900 there has been a revival 



ifo CAPITAL 

of convertible issues, which is to be explained chiefly on the 
ground of increased demand for capital. 

Among the convertible bonds now outstanding may be 
mentioned : 

Atchison 4's, due 1955, which were convertible up to 
June 1, 19 1 3, into common stock at 100. 

Union Pacific Debenture 4's, due 1927, convertible prior 
to July 1, 191 7, into common stock at 175. 

American Telegraph and Telephone Company's deben- 
ture 4's, convertible up to March 1, 191 8, into stock 
at 1337374. 

Participating bonds attempt to offer a like advantage by 
giving to the bondholders a right to share in excess profits 
after all the obligations of the company have been provided 
for. They are like income bonds except that it is obligatory 
on the part of the company to pay the fixed rate of interest, 
and the participating feature applies only to excess payments. 
The best known issue of this kind was the "Oregon Short Line 
Cumulative Trust Participating 4's" issued in 1903 but almost 
immediately retired, which were to receive 4% interest plus 
whatever dividends in excess of this amount were declared 
upon the stock of the Northern Securities Company, deposited 
as collateral. 

An English issue of the same type consists of the profit- 
sharing debentures of the Anglo-Netherlands Sugar Corpora- 
tion, which bear interest at 5% and in addition are entitled to 
25% of the surplus net profits remaining after the sinking fund 
has been provided for and after 5 % has been paid on ordinary 
shares, "such participation, however, being limited to an ad- 
ditional 2^%." In other words, these debentures cannot 
under any conditions pay more than 7^/2%. Participating and 
profit-sharing bonds have not proved especially popular either 
in the United States or in England. 



BORROWED CAPITAL-LONG-TERM j6i 

Sinking Funds 

The sinking fund principle first came into prominence in 
the latter part of the eighteenth century, when it was ad- 
vocated and applied by William Pitt as the best and easiest 
means of providing for the repayment of the United King- 
dom's huge national debt. It was heralded by many people 
at the beginning as a remarkable method of repaying the loan 
without any perceptible sacrifice. As a matter of fact, this is 
in many instances the truth of the case. Corporations are 
run by human beings who are more than likely, if left to 
their own devices, to make inadequate provision for the future. 
An officer of a corporation which has just floated, let us say, 
a 25-year loan, is likely to consider that his duty has been 
done; his corporation has received a large amount of fresh 
capital which can be profitably used, and the earnings of 
which (after deducting the interest payments) will go to 
increase the yield on outstanding stock. It is easy for him 
to think that it is not his part to worry as to the repayment 
of the loan. When it begins to approach maturity, he, or his 
successor, will consider how it should be handled. 

Against this every-day human attitude of directors and 
managers of borrowing corporations, there are opposed the 
interests of the buyer of the bond and of his representative 
in the preliminary negotiations, namely the banking firm which 
undertakes to dispose of the bond issue. The investor wants 
to make sure that his money will be repaid when due. Further 
than that, he wants to make sure that there will be no depre- 
ciation in the market value of his holdings. He is well aware, 
as every lender must be, that the borrower's natural instinct 
is to let the future take care of itself. If he is wise, he is 
strongly inclined to insist that some definite measures be 
adopted which will fully protect him against the carelessness 
or easy-going optimism of the people to whom his money has 
been entrusted. 



!6 2 CAPITAL 

This wise demand on the part of the investor can readily 
be met without great difficulty. The fundamental reason for 
the sinking fund or some other method of beginning at once 
to repay a loan, is to be found in the fact that comparatively 
small amounts set aside each year out of the corporation's 
earnings will assure repayment, unless the corporation has 
overborrowed. The annual provision, accumulating as it does 
at compound interest, will not be a serious burden. Accumu- 
lating at the rate of 6%, a sinking fund of approximately 
4.3% per year will provide for repayment of a loan at the end 
of 15 years; accumulating at a rate of as little as 3%, a sink- 
ing fund of 2.8% per annum will provide for repayment of 
a loan at the end of 25 years. 

A corporation should be able to withhold these amounts 
and yet have ample funds remaining, if it is reasonably pros- 
perous, for dividends to its stockholders. It is clear from 
the approximate figures cited, that the repayment of a loan 
by annual deductions from income is especially appropriate 
in the case of loans running from 20 to 50 years. The length 
of the loan will, of course, depend upon the character and 
stability of the business. A loan to a railroad company may 
properly run, it is generally considered, for as long as 50 
years. A loan to an industrial corporation will ordinarily not 
run longer than 25 years. Inasmuch as the profits of in- 
dustrial corporations are expected to average higher than the 
profits of transportation companies, it is clear that they should 
be able to carry a larger sinking fund. 

Although many corporations combat the tendency, there 
can be little question but that the demand for some form of 
sinking fund or other annual repayment is growing. The 
Committee of the American Investment Bankers' Association 
on Railroad Bonds and Equipment Trusts, included among its 
recommendations at the 191 5 meeting of the association, that 
"railroad mortgages should contain provisions for sinking 



BORROWED CAPITAL— LONG-TERM ^ 

funds, and that such sinking fund payments should be recog- 
nized by the rate-making bodies as an operating expense of 
the railroad corporation." 

In popular usage the term "sinking fund" is applied almost 
indiscriminately to any method of providing for repayment 
of a long-term loan during its life, by setting aside a prede- 
termined amount at regular periods for that purpose. This 
process is known in more technical language as "amortiza- 
tion." In its proper sense, amortization includes four principal 
methods as follows : 

1. The borrower may turn over fixed cash payments at 

regular periods, usually once a year or once every 
six months, to a trustee ; the trustee may deposit or 
invest the money at his discretion within the limits 
determined in the original agreement. 

2. The borrower may set aside fixed sums at regular 

intervals and deposit or invest these sums at his own 
discretion within the limits of the agreement. 

3. The borrower may set aside sums at regular inter- 

vals and use them solely for the repurchase of the 
bonds which are being amortized. 

4. The bonds may be arranged to mature in series so 

that a predetermined proportion will fall due each 
year, thus forcing the borrower to repay the bonds 
gradually during the life of the whole issue. 

The first two methods are the ones originally in view under 
the sinking fund plan. They are still used to a considerable 
extent in the repayment of municipal and some other govern- 
mental loans, but are seldom to be found in private corpora- 
tions. The third and fourth methods are in one important 
respect similar, since the sums set aside out of income are 
used under both methods for the redemption of the borrower's 
own obligations, not for the purchase of outside securities. In 



164 CAPITAL 

applying the third method, the bonds which are repurchased 
by the corporation are frequently kept alive. Interest payments 
on them are maintained, in which case it may properly be 
designated as one variety of sinking fund. In other instances 
the bonds that have been redeemed are cancelled, in which 
case the third method closely resembles the fourth method. 

There are certain objections to all these methods which 
may briefly be stated. When the first-named plan of turning 
over regular payments to a trustee is followed, there is always 
to be considered the possibility that the trustee may invest the 
funds with a view primarily to his own advantage, or may make 
unsound investments, in which case it is quite possible that the 
fund may not accumulate as rapidly as had been expected in 
advance. The possibility of making unwise investments is 
almost equally to be feared under the second method. Fur- 
thermore, the average rate of return on high-class investments 
varies considerably over a long period of years, and this may 
make impracticable even an approach to the rate of accumula- 
tion which had been calculated in advance. It is, in fact, a 
matter of common knowledge that sinking funds invested in 
outside securities seldom come up to the expectations of those 
who plan them. The final, and perhaps most serious, objection 
to both the first and second methods is that high-grade invest- 
ments, which are the only ones suitable for sinking funds, yield 
a comparatively small rate of return; as a matter of fact, the 
rate of interest received on such securities usually is consid- 
erably less than the interest which is being paid by the cor- 
poration on its own obligations. 

These objections have proved so powerful and well 
founded, that it has come to be almost universally accepted as 
correct practice to carry on amortization through the redemp- 
tion of bonds which are being amortized. -The practical ques- 
tion for most corporations to consider is whether it is best to 
set aside fixed amounts for the redemption of their securities, 



BORROWED CAPITAL— LONG-TERM ^5 

or to arrange for serial maturity of these securities. For short- 
term loans the tendency is strongly toward the convenience and 
simplicity of the last-named method. For long-term loans, 
however, the third method is probably better adapted. There 
are two fundamental reasons for this preference : first, when 
an issue of long-term bonds has different dates of maturity, it 
is necessary to fix a distinct price for each maturity, which is 
inconvenient and in large part offsets the advantage of ready 
marketability which should attach to all large bond issues; 
(second, unless the amount falling due at each date of maturity 
is arranged on a graduated scale so that the amounts become 
progressively larger, the burden on the corporation is heavier 
at the beginning when interest payments on the whole issue 
must be met, and is gradually lightened as more and more of 
the bonds are redeemed and interest payments are thereby 
reduced.^ It is far better, if possible, to retain the advantage of 
uniformity in the life of all the bonds in one issue, and of an 
equal distribution of the burden over a period of years, both of 
which are attractive features of the original sinking fund plan. 
The simplest and no doubt the favorite device for meeting 
all these objections, is to establish a sinking fund and invest 
the fund solely in bonds that are being amortized. Among the 
beneficial results of this method are the following : 

1. The corporation is protected against any loss due to 
unwise investment, when it is buying its own bonds, and 
thereby reducing its outstanding obligations. It is certainly 
in no danger of losing its money. 

2. The rate of interest earned is the same as the yield of 
the market price of the bonds that are being amortized. This 
is an accurate statement, at least under the customary provi- 
sions that the bonds may be redeemed for the sinking fund 
at par or slightly above, or may be purchased in the open 
market at the option of the corporation, in case the market 
price is below the fixed redemption price. If the bonds are 



J66 CAPITAL 

selling on a 6 or 7% basis, it is clear that the sinking fund 
will accumulate at the same rate. 

3. Under the customary provisions just referred to, the 
market price of the bonds is maintained by the corporation's 
repurchases or redemption, and in this way the credit of the 
corporation is supported. 

4. There is nothing to prevent making a single quotation 
for all bonds in the issue. If a corporation buys in the open 
market, it takes whatever bonds happen to be for sale at the 
market price. If it redeems a fixed proportion of bonds each 
year, the bonds to be redeemed are customarily determined by 
lot. In this last practice there is a slight element of uncer- 
tainty which might be considered objectionable, but it is of 
small practical importance. 

5. The burden on the corporation is equally distributed 
during the life of the bond issue. The simplest plan for 
accomplishing this result is to keep alive all the bonds pur- 
chased for the sinking fund, so that the corporation pays out 
the same amount of interest each year. As the number of 
bonds held in the sinking fund increases more and more, in- 
terest payments, it is clear, go to swell the sinking fund, and 
thus to increase the annual purchases or redemptions. But 
so far as the burden on the corporation is concerned, it re- 
mains the same year after year. 

There seems to be little room for question that among all 
the methods of amortization, the best and simplest is the one 
just described of establishing a sinking fund which is used 
for the repurchase and redemption of all the bonds that are 
being amortized, and keeping alive the bonds that are taken 
into the sinking fund. 

A Novel Proposal 

It may be of interest to readers in connection with the 
preceding review of sinking fund methods, and as showing 



BORROWED CAPITAL— LONG-TERM ^y 

how the principles that have been stated are applied in prac- 
tice, to review briefly a somewhat novel proposal for the 
redemption of a bond issue which was presented to the writer 
some years ago. The proposal may be regarded as typical of 
a number of ingenious plans which on analysis are generally 
found to be unsound. 

The essential points of the proposal may be stated as 
follows : 

A manufacturing concern, a corporation, wishes to 
increase its working capital by $400,000. It has at pres- 
ent about $300,000 worth of paper in the banks and 
desires to make this a permanent loan in order to be 
able to take care of future increase of business by addi- 
tional bank credit if it should be necessary. The plan 
under consideration is the issue of $400,000 of 50-year 
6% debenture bonds without any mortgage, secured by a 
general charge against the property. 

A redemption fund is to be provided by the corpora- 
tion's procuring a trust company to act as trustee for a 
fund of $72,000. This is to be invested at the trust com- 
pany's discretion, so that it will yield 4% per annum, and 
the above amount at this rate, compounded semiannually, 
in fifty years will amount to $520,000, or $120,000 more 
than sufficient to pay the bonds at maturity. 

The borrowing corporation would therefore receive 
from this issue $328,000 and at ;he expiration of the 
50-year term $120,000 additional. 

The trust company's remuneration is to come from 
whatever it can make above 4% on this $72,000. 

Will you give me your opinion as to whether you 
would consider this good business on the part of the 
corporation and what you would think of the bonds 
aside from the question of the credit of the borrowing 
company. 

In putting this matter before a trust company to act 
as trustee, for the redemption fund, what objections, if 
any, would likely be made? Do you know of any bond 
issues of this kind? 



1 68 CAPITAL 

The reply to this inquiry was as follows: 

Your plan for providing for the ultimate redemption 
of a bond issue, is unusual. We do not know of any 
bonds issued under similar conditions. For the reasons 
presented below, the plan seems to us wasteful and objec- 
tionable. 

First, and most important of all, it would seem to us 
very unwise to turn over $72,000 to any individual or 
institution to be invested at the discretion of the trustee, 
with the provision that the trustee is to retain as profits 
whatever income is secured above 4%. Under this 
arrangement the trustee is given every inducement to 
secure just as large an income as possible, even if the 
principal be risked. In other words, the trustee is left 
free to speculate with other people's money. 

It may be claimed, on the other side, that a highly 
reputable conservative trust company would be chosen as 
trustee and that this trust company would be responsible 
for the original sum with interest compounded at 4%. But 
you must remember that 50 years is a long time and that 
no man can foresee what changes in ownership and 
management may take place before the end of the period. 

Moreover, 4% is about all that can be secured on 
thoroughly safe investment bonds at the present time. 
The proposed plan, therefore, would make it imperative 
on the trustee to invest in more or less doubtful securi- 
ties. Under these conditions, we doubt very much if 
any first-class trust company would consent to act as 
trustee. 

The rate of return on sinking funds invested in out- 
side securities is always uncertain, and, as experience 
has shown, almost always disappointing. The best 
modern practice in handling sinking funds, therefore, is 
to invest them in the very bonds which the sinking fund 
is designed to protect. These bonds may be secured 
either by purchase in the open market or by providing at 
the beginning that they may be called and redeemed at 
a good price, usually considerably above par. As bonds 
backed by sinking funds usually bear comparatively high 



BORROWED CAPITAL— LONG-TERM 169 

rates of interest, this method of investment is not only 
safe, from the corporation's standpoint, and the returns 
certain, but also results in a much larger saving than is 
possible by conservative investment in outside securities. 
In the present case, for instance, a. sinking fund so 
invested would yield a return of 6% instead of 4%. 

Another criticism of this bond issue is that the life 
of the bond is too long. Scarcely any industrial cor- 
poration is so firmly established that its bonds can safely 
be bought when they run over a 50-year period — not, at 
least, unless some of the bonds, as with the United States 
Steel issue, are bought up and put into the sinking fund 
each year. For this reason alone we do not believe that 
the bonds under the proposed plan would find a ready 
market. 

Another objection is that the proposed plan is ex- 
pensive. The corporation, assuming that the bonds are 
sold at par, will secure $400,000, $72,000 of which will 
go into the redemption fund, leaving only $328,000 for 
the company. The $72,000 will draw only 4% ; yet the 
company must pay 6% on the whole $400,000. 

The net expense to the corporation consists of the 
yearly interest payment less the annuity which, if set 
aside each year and invested at 4%, would equal $120,000 
at the end of 50 years. This annuity is $786.02. The 
net expense to the corporation, therefore, is $24,000 less 
$786.02, which equals $23,213.98, equivalent to 7.08% on 
the $328,000 actually received. 

If, instead of the redemption fund, the ordinary 
sinking fund invested in outside securities at 4% were 
used, the yearly exoense would be as follows: 

6% on $328,000 $19,680.00 

Plus sinking fund yearly payment which 
accumulating at 4% would equal $328,000 at 
the end of 50 years 2,148.47 

Total $21,828.47 

This latter sum is 6.65% on $328,000. 



!^ CAPITAL 

If the sinking fund, as suggested above, were invested 
in the corporation's own bonds, there would be a still 
greater saving. The exact amount of this saving would 
depend on the price at which the bonds were redeemed 
or bought in the open market, and cannot, therefore, be 
calculated precisely in advance — not at least unless the 
rate of redemption is fixed at the time the bonds are 
issued. 

Other Methods of Safeguarding Bonds 

The bond issues put out by mining companies, lumber 
companies, and other concerns, the chief property of which 
consists of "wasting assets" — that is, assets which in the ordi- 
nary course of business are used up and not replaced — are 
customarily protected by sinking funds calculated on the an- 
nual wastage. Timber bonds, for instance, which are secured 
by tracts of standing timber, are customarily issued up to 
about 50% of the market value of the timber. The mortgage 
securing the bonds must contain strict provisions which 
operate to insure the regular deposit of an agreed amount per 
thousand feet for all timber cut sufficient to retire all the 
bonds when about one-half of the timber is consumed; these 
deposits to be applied to the payment of principal of the bonds 
as the several serials, semiannually or annually, become due. 
The mortgage makes provision for keeping careful check upon 
the cutting of the timber and accounting for the same to the 
mortgage trustee.* 

$3 to $3.50 per thousand feet of lumber seems to be 
generally regarded as a fair sinking fund provision. The same 
principle is followed in accumulating sinking funds for mines. 
For example, the Great Lakes Coal Company sets aside for 
this purpose, 5 cents per ton, run of mine coal. The Iroquois 
Iron Company sets aside 25 cents for each of the first 400,000 
tons of iron ore mined and shipped each year, with an addi- 



*Extract from circular issued by Messrs. Clark L. Poole and Company, quoted 
in T. S. McGrath's "Timber Bonds," p. 34. 



BORROWED CAPITAL— LONG-TERM 17 X 

tional 15 cents per ton on all shipments running in excess of 
400,000 tons. 

There are many different special provisions for the main- 
tenance of sinking funds and for giving greater security to 
bondholders. In 1889 the New England Cotton Yarn Com- 
pany issued $6,500,000 5% first mortgage bonds which were 
covered by a sinking fund of 1% on the outstanding amount, 
payable before any dividend disbursements on the preferred 
stock, with an additional sinking fund of 4% payable before 
any dividend disbursements on the common stock. The Bald- 
win Locomotive Works has an authorized issue of $10,000,- 
000 first sinking fund gold 5's, the mortgage of which provides 
that the net quick assets of the corporation shall at all times 
equal the aggregate indebtedness including the outstanding 
bonds. Similar provisions requiring that net quick assets 
shall bear a fixed relation to the total indebtedness are not 
uncommon with manufacturing and trading companies. 



CHAPTER VIII 

BASIS OF CAPITALIZATION 

Definitions 

We have now considered the financial forms of organiza- 
tion of business enterprises and the various types of security 
issues which are exchanged for cash and other property ac- 
quired by the business. The total par value of all the security 
issues outstanding at any given time is usually referred to 
as the "capitalization" of an enterprise. In some jurisdictions 
there is a legal meaning attached to the word "capitalization" 
which is wholly distinct from its popular meaning; it being, 
in the legal sense, the total par value of the authorized capital 
stock of a corporation. Wherever the word is used in this 
volume, however, it may be understood in its popular sense. 

"Capitalization" is distinguished from "capital" or "capital 
funds," by which we mean the actual value of the investment 
in the business. The vague expression "overcapitalization" 
is intended to indicate a state of affairs where the nominal 
value of the outstanding stocks and bonds is in excess of the 
real value of the investment. It has already been pointed out 
in discussing methods of paying for capital stock, that there 
need not necessarily be a close correspondence between "capi- 
talization" and "capital" or "capital funds" actually invested. 

Another phrase frequently used which should be dis- 
tinguished, is "capital assets," under which term are included 
those assets of a business which are of a permanent nature 
and which are essential to its continuance. "Capital assets" 
are distinguished from "current assets." If a manufacturing 
concern, for instance, has a plant worth $1,000,000, inven- 
tories of $300,000, and cash and accounts receivable of $200,- 

172 



BASIS OF CAPITALIZATION 1 73 

000, we should say that its capital assets were $1,000,000 and 
its current assets $500,000. 

The capitalization of an enterprise is in a sense a valua- 
tion on the part of the organizers of the net worth of the 
enterprise. At the beginning it is supposed to be, at least as 
a matter of legal theory, a fairly accurate valuation. As 
time goes on, it is recognized that there will necessarily be 
changes in the status and value of the various assets and 
liabilities; and the financial results of these changes are sup- 
posed to be shown in the surplus or profit and loss accounts. 
The "capitalization" plus the surplus theoretically measures 
the exact value of the permanent investment in the business. 
However, the necessary inaccuracies and arbitrary estimates 
of accounting practice make it very difficult even to approach 
this theoretical relation in every-day practice. 

Three Bases of Capitalization 

The question: "What is the right basis of capitalization?" 
is almost identical with the question: "What is the best 
measure of wealth?" To this latter question there are three 
possible answers. The most obvious is that wealth is measured 
by the cost of the property which is owned, plus whatever 
surplus value has been accumulated. Thus, if a farm cost 
$10,000 and has been improved to the extent of $500 a year, 
it should, in the course of two years, be worth $11,000. But, 
supposing that before the end of the two years some one 
in the neighborhood struck oil? The property would imme- 
diately acquire a value which would have very little reference 
to the original investment in the accumulation of betterments. 
Unexpected factors wholly outside the control of the owner of 
property are continually modifying its value so that it is quite 
out of the question for anyone to depend wholly on records 
of his investments and of accumulations as a method of 
measuring his wealth. 



174 



CAPITAL 



The second method is to measure wealth by the cost of 
reproducing property. If a man has a factory which has been 
running for 20 years, he may be ready to grant that his 
records of investments and accumulations would be of little 
use in determining its value but he might suggest that the 
present cost of building another plant of the same quality and 
size would be a correct measure of its value. This may be 
accepted as satisfactory so far as strictly tangible assets are 
concerned. But to every piece of property there attaches a 
certain intangible value. A man running a successful retail 
shop would not be willing to part with it, ordinarily, in ex- 
change for another shop which was just as well fitted up and 
carried the same stock but which had been unsuccessful. A 
street railway company that was running smoothly and in 
harmony with the public sentiment of its territory would not 
accept in exchange for its track and rolling stock the exactly 
similar assets of some other company which had incurred 
public ill-will. It is possible — at least theoretically — to re- 
produce physical assets, but it is impossible to reproduce good- 
will, organization, prestige, and the like. Hence, the attempt 
to measure wealth by figuring the cost of reproducing proper- 
ties breaks down as soon as we begin to measure the value of 
intangible assets. 

The third method is the capitalization of earning power. 
One man owns a piece of real estate, which brings him a clear 
net income under a long-term lease, of say $50,000 a year; 
another man owns a piece of property for which he paid just 
as much but which yields only $10,000 a year. Assuming that 
these two incomes are equally stable, can there be a question 
in anyone's mind that the first property is worth five times 
as much as the second? Note the assumption that the two 
incomes are equally stable. The likelihood of continuance of 
earning power and the ease with which it may be transferred 
are, of course, important factors to be considered. To what 



BASIS OF CAPITALIZATION 



175 



extent they should be allowed for, and in what way the value 
of any given property is to be determined on the basis of its 
earning power, are questions to be discussed a little farther 
on in this chapter. It is enough here to point out that earning 
power is the chief result of tangible and of intangible assets. 
If we take into account not merely current earnings but also 
potential earnings, then we have here a measure of wealth 
which must be a true and satisfactory measure. After all, 
in buying property for business reasons, what do we buy? 
Not merely so much real estate or so many articles. We are 
buying income. In the same way a man's individual wealth is 
shown, not by what he has invested — which may have been 
chiefly wasted — but by what he is getting out of his invest- 
ments. If the answer that earning power is the best measure 
of wealth is granted, and if the proposition that "capitaliza- 
tion" of an enterprise is an approximate estimate of its wealth 
is accepted, then it would seem to follow that the correct basis 
of "capitalization" is earning power. This answer, however 
simple and sound it may appear to us, is not a principle of 
the law governing corporations which, on the contrary, as- 
sumes that investment is the only correct basis of capitaliza- 
tion. Out of this conflict between legal theory and business 
practice grow many difficulties and evasions. 

Investment as a Basis of Capitalization 

Small and close corporations are usually started through 
informal agreements among a few men who are personally 
acquainted with each other. Each one of these men subscribes 
to a certain amount of stock of the new corporation and pays 
for his stock either in cash or by turning over property at a 
value agreed upon with his associates in the enterprise. With 
comparatively few exceptions, corporations of this type issue 
their bonds and capital stock at a par value exactly or nearly 
equivalent to the cash or cash value which the corporation 



iyS CAPITAL 

receives. Thus at the beginning there is an actual corre- 
spondence between the capitalization, the investment, and the 
actual net worth of the corporation's assets. If the enterprise 
operates along well established lines, has the correct amount 
of capital, and earns a normal rate of return, there will be 
little divergence from this system of approximate equality 
among the three factors mentioned. Ordinarily, however, the 
vicissitudes of business soon bring about variations. With 
a larger corporation there is usually no very close correspon- 
dence, even at the beginning. It has been remarked: "New 
companies nearly always start with a burden on their backs. 
Either they have to spend a great deal in order to get their 
capital, or they pay a great deal for the good- will of an 
established business."* 

The wide discrepancy that may exist between investment 
and actual value is most forcibly illustrated by the history 
of the so-called "Cordage combination" which began as the 
National Cordage Company in 1887, became after the first 
reorganization in 1893 the United States Cordage Company, 
and after the second reorganization in 1895 tne Standard 
Rope and Twine Company. Arthur F. Dewing has calculated 
the results to the original investors in this unfortunate enter- 
prise as follows: 

For purposes of illustration consider a private in- 
vestor having bought ten shares of the National Cordage 
Company's preferred stock of Belmont & Co. in 1890. 
In the reorganization of the National Company he was 
compelled to buy twenty per cent more of the pre- 
ferred stock, all of his holdings becoming second pre- 
ferred. He would, therefore, come into possession of 
twelve shares of the United States Cordage Company's 
second preferred stock — cost $1,200. He received no 
dividends. In the reorganization of the United States 
Cordage Company, the second preferred stock was as- 



f Hartley Withers on "Stocks and Shares," p. 74. 



BASIS OF CAPITALIZATION 177 

sessed $10 a share and received $10 a share of the First 
Mortgage Bonds of the Standard Rope and Twine Com- 
pany and forty per cent of stock. The investor in 
question would be assessed $120 — making his actual in- 
vestment $1,320. He received $120 in the Standard Rope 
and Twine Bonds and $480 in stock. In the reorganiza- 
tion of the latter Company the stock was extinguished. 
The bonds were worth thirty-nine per cent and, if re- 
tained, would be subject to an assessment. The $120 
in bonds represented an actual value to the investor of 
$46.80. Meanwhile, he would have lost the interest on 
the investment for upwards of twelve years. Taking 
this at the rate of five per cent the indirect loss 
amounted to $780. A man who invested $1,000 in the 
first and underlying security of the National Cordage 
Company would, in 1905, have increased his actual in- 
vestment to $1,320, and including interest to $2,100. For 
this he would have stock that was worthless and bonds 
having a market value of $46.80 and subject to further 
assessment.* 

On the other side may be given numerous examples of 
corporations the fortunate stockholders in which have seen 
the market value of their shares rise with great rapidity. It 
needs no further argument to satisfy every one that however 
closely investment, capitalization, and net worth may corre- 
spond at the beginning of an enterprise, they are likely to 
diverge more and more as time goes on. 

Capitalization of Initial Expenses and Losses 

A question which arises in the early history of most cor- 
porations, and which is of considerable practical importance, 
concerns the propriety of capitalizing initial losses and ex- 
penses. Every new corporation must expect to incur a loss 
during the period between the time it starts operations and 
the time its business is on a normal basis. This period may 

"Dewing's "Corporate Promotions and Reorganizations," pp. 159-162. 



l yg CAPITAL 

be long or short, depending upon the nature of the business. 
With many companies such as railroads, large manufacturing 
establishments, publishing concerns, developers of urban real 
estate, and the like, the period is apt to be several years in 
length. With trading companies the period should be rela- 
tively short. The excess of expenditures over income during 
this period is frequently charged to some capital account or 
accounts, such as "Development Expenses," "Organization 
Expenses," "Good-Will," or "Deferred Expenses." When a 
business comes to be on a normal basis and is earning profits, 
then initial expenses and losses may either be written off or 
may be transferred to some permanent capital account, thus 
providing a basis for a later increase in capitalization. 

The same question arises in connection with interest pay- 
ments on bonds that have been issued during the process of 
construction and development of a company and in connection 
with discounts on bonds sold below par. In a well-known 
English case it was decided in 1906 that "where a company 
borrows money to construct permanent works the interest paid 
during the period of construction might properly be treated as 
a part of the cost of construction and charged to capital."* 

The English Companies' Consolidation Act of 1908 spe- 
cifically provides that where shares are issued to defray ex- 
penses of construction, the company may pay interest on such 
shares and charge the payments to capital accounts, with the 
provisos that the payment be authorized by the stockholders 
and by the Board of Trade ; that it shall not continue more 
than six months after construction is complete; that the rate 
of interest shall not exceed 4% ; and that the transaction be 
clearly shown in the company's books of account. In this 
country much the same practice is found as in England, 
although it is not so definitely authorized. 



*Hines v. Buenos Aires Grand National Tramways, 2 Ch. 654; quoted in Gore- 
Brown and Jordan's handbook on "Joint-Stock Companies," p. 283. 



BASIS OF CAPITALIZATION 



179 



There seems to be no serious objection to be urged, al- 
though the practice may sometimes favor abuses. Examples 
might be cited of companies which have little or no prospect 
of success and yet have gone on for a period of four or five 
years charging the losses on their normal operations to a fic- 
titious capital account, thus rendering a forced statement of 
alleged profits to their shareholders. These isolated abuses, 
however, are hardly to be taken as sound objections to a prac- 
tice which is in itself correct. We are probably quite justified 
in saying that the total investment in an enterprise includes a 
reasonable allowance for expenses and losses incurred in carry- 
ing through the initial organization and development. 

Capitalization of Earning Power 

We have already touched upon the fundamental reasons 
for regarding earning power as the proper basis of capitaliza- 
tion. This principle is generally accepted as correct in the 
United States, England, France, and other commercial coun- 
tries except Germany, wherein the laws insist with much 
strictness on a close correspondence between capitalization and 
investment. Speaking on this point, Paul M. Warburg, now a 
member of the Federal Reserve Board, wrote several years 
ago: 

Stock-watering, that is, capitalization of earning power 
or good-will, is permitted in England and France, while 
it is not allowed in Germany. While personally I prefer 
the German system, it is a mistaken idea to think that 
the capitalization of earning power necessarily means 
taking advantage of somebody. If the German sells at 
200% an industrial stock paying 10% dividends, it 
amounts to the same as if the Englishman had sold at 
par twice the amount of shares on which 5% dividend 
is paid.* 



*Quoted from, article on "American and English Banking Methods Compared," by 
Paul M. Warburg, in North American Review, 1908. 



l8o CAPITAL 

Capitalization on the basis of earning power is not neces- 
sarily the result of a carefully thought-out plan. On the con- 
trary, it usually is the by-product of an effort on the part of 
the managers of corporations to make their holdings as attrac- 
tive as possible so as to be able to sell them at the highest 
possible price. It is for this reason that corporations which 
have shares that are actively dealt in are more generally capital- 
ized on an earning power basis than are the corporations which 
are closely held. It has been found through long experience 
that shares which sell at or below par have a readier market 
and command a higher price in» proportion to their yield than 
do shares which are quoted far above par. "If a company is 
showing earnings of 40% on its common stock but is paying 
only small dividends, it will be found difficult, in all proba- 
bility, to sell such shares at a price commensurate with their 
intrinsic value. But, if the same company through some device 
quadruples its capitalization so that the earnings on each share 
amount to«io%, it may safely be- assumed that the new shares 
will sell for more than 25% of the market price of the old 
shares. 

There is very little, if any, sound reason for the preference 
generally shown for shares that sell near or below par. Two 
explanations, however, may be. offered: First, there is a some- 
what wider market for low-priced shares, due to the fact that 
they are usually bought and sold in lots of 10 or more; it is 
obvious that there are more people who can buy a lot of 10 
shares worth $40 each, than a lot of 10 shares worth $400 
each. Second, there is an impression in the mind of the 
average shareholder — a vague impression but powerful — that 
his stock either had or will have a real value about equivalent 
to its par value. If he buys below par, he sees a prospect, at 
least, of appreciation in the value of his holdings. This im- 
pression, we may grant at once, is based on a misconception. 
Many shareholders do not seem fully to understand that their 



BASIS OF CAPITALIZATION !8i 

property rights consist, practically, only of an equity, and 
that the corporation is under no obligations ever to return or 
account for the par value of their shares. Nevertheless, there 
is an imaginative appeal in the magic term "$ioo" stamped on 
the face of a stock certificate, which undoubtedly helps to sell 
low-priced shares. 

The rate of capitalization of earning power of a corpora- 
tion depends naturally on the corporation's stability and on 
the nature of the business. A railroad or public utility com- 
pany may find stock which yields only 5 to* 7% selling at or 
near par. The shares of a manufacturing or trading com- 
pany must usually earn 8 to 12% or 15% if they are to sell 
at par. These percentages do not refer solely to dividends, 
but to the actual net earnings of the corporation after all claims 
prior to dividends on-the'common stock have been met. There 
is, of course, no definite rule for determining what percentage 
should or will be used in. working out the capitalization. That 
must be determined by observing the market action of the 
company's shares and of other similar shares. 

There is a perceptible tendency, which it is. interesting to 
bear in mind, toward establishing an approximate equality 
between the outstanding capitalization of a company and its 
gross earnings. Note that the relation is with gross earnings, 
not with net earnings. When the F. W. Woolworth Company 
(owner of the well known chain of 5 and 10 cent stores) was 
incorporated in 19 12, the estimated earning capacity was capi- 
talized at $50,000,000, or over 80% of the entire capital stock. 
This figure was* almost equivalent to the company's gross sales 
of the preceding year. 

Following is a compilation showing the stocks and bonds 
outstanding in the hands of the public, the gross sales, and 
the percentage of gross sales to outstanding capitalization in 
each case:* 



•Adapted from article in Wall Street Journal, August 26, 1915. 



l82 CAPITAL 

Proportion of 

Company Total Gross Gross to 

Capitalization Capitalization 

General Motors $39,338,983 $85,373,302 2.17 

American Smelters 158,976,498 200,925,625 1.26 

General Electric 83,885,987 90,467,691 1 .08 

American Tobacco 73,139,626 69,339,083 .95 

Westinghouse 46,967,444 33,671,485 72 

Pressed Steel Car 21,866,665 13,375,090 .61 

American Locomotive 56,702,530 29,987,438 .53 

U • S Steel 1,498,643,673 558,414,933 -37 

Republic Iron & Steel 69,180,414 21,366,249 .31 

Baldwin Locomotive 48,390,523 13,616,163 .28 

It will be noted that the five companies at the bottom of 
the list above, had all been going through a period of excep- 
tionally slack business when this table was compiled. Ordi- 
narily their gross would run a great deal higher. Making 
this allowance, we find only one radical exception in the above 
table to the general rule that capitalization and gross earnings 
tend toward an equality. This exception is the General Motors 
Company, the stock of which is selling at a high price; it is 
rumored that this company is likely to increase its capitaliza- 
tion at the first good opportunity. 

The correspondence applies chiefly in manufacturing and 
trading operations and not at all in the railroad or public 
utility field. This may best be shown by the following tabu- 
lated comparisons of capital, gross returns, net returns, and 
percentage of net returns to capital, as shown by the United 
States Census returns for 1900, 1905, and 1910: 

Manufacturing Establishments 

Percentage of 
Year Capital Gross Returns Net Returns Net Returns 

to Capital 
iqoo $8,975,256,000 $11,406,927,000 $1,536,502,000 17 

1905 12,675,581,000 14,793,903,000 1,655,643,000 13 

1910 18,428,270,000 20,672,052,000 2,218,972,000 12 

Railroads 

Percentage of 
Year Capital Gross Returns Net Returns Net Returns 

to Capital 
1900 $10,263,313,000 $1,487,045,000 $477,284,000 4.7 

1905 11,951,349,000 2,082,482,000 628,406,000 5.3 

1910 14,387,816,000 2,750,667,000 824,241,000 5.7 



BASIS OF CAPITALIZATION 



183 



If we assume that the capital invested both in manufac- 
tories and in railroads is represented by an approximate equal 
market value of bonds and shares outstanding — which is, 
perhaps, not far from the truth — then the above figures give 
us the average rate of yield which the investor in the shares 
of railroad and of manufacturing companies may reasonably 
expect. 

Although it is not possible to secure exactly corresponding 
data for other countries, it may be of interest to compare the 
above percentages with the yields on capital invested in various 
lines of business in Germany for the year 1908, which were 
as follows :* 

Banking y.y% 

Insurance T 9-3% 

Chemical Industry I S-7% 

Large Scale Chemical Enterprises II «5% 

Mining, Smelting, Salt Works, etc 9-5% 

Textile Industries 94% 

Electrical Industries 8 % 

Street Railways 4-3% 

The average profits and dividends for various lines of in- 
dustrials in Russia for 191 1 were as follows :f 

Average Average 

Profits Dividends 

Mining 13.8% 5.5% 

Textile 13.5% 5.4% 

Credit Institutions 15.1% 11 % 

Machinery H-7% 4-4% 

Foodstuffs 15 % 6.6% 

Commercial Concerns *3- 1 % 7 % 

Chemical Industries 3 2 -9% 9 % 

Insurance 20.6% 12.2% 

♦"The German Great Banks," by Dr. J. Riesser, reprinted for the National Monetary 
Commission, Washington, 1911, p. 464. 

f'Why Investments Pay in Russia," by Alexander Znamiecke, in The Americas, 
June, 1915. 




184 CAPITAL 

The reason for the correspondence — or the tendency 
toward correspondence — in the two factors named above, 
which at first glance would be regarded as unrelated, is found 
in the fact that the percentage of net earnings to gross business 
tends to vary in inverse proportion to stability and in direct 
proportion to the risk of the business. This sounds like an 
extremely abstract and difficult proposition, though it is 
actually simple and practical. A company which is running a 
street railway system is engaged in a business that is well 
standardized and is subject to little risk as to fluctuation; con- 
sequently, there is a great deal of competition or potential 
competition among capitalists who are willing to put their 
money into the business, and the ratio of profits to gross 
earnings is reduced to a small percentage. On the other hand, 
the business of manufacturing a novelty which may quickly be 
displaced is risky, and capital will be invested only by persons 
who are experienced in the business. For both these reasons, 
the ratio of profits to earnings or sales must be exceptionally 
high in order to attract sufficient capital. The same factors 
precisely are at work in determining how large earnings must 
be in order to make the shares of various companies command 
a market price not far removed from their nominal value. 
The percentage of net profit on sales, and the percentage of 
yield on investments in the company's shares, will be about 
the same. Hence, it necessarily follows that capitalization 
tends to adapt itself and to become equal to gross business. It 
is perhaps unnecessary to repeat that this is only a tendency 
and by no means an invariable rule. 

Many examples of the adjustment of capitalization to 
earnings might be cited; indeed, almost any large industrial 
corporation, the shares of which are widely traded in, would 
serve this purpose. At its reorganization, the United States 
Realty and Construction Company had tangible property worth 
approximately $11,000,000, and cash amounting to about 



BASIS OF CAPITALIZATION ^5 

$11,000,000, against which was issued $27,500,000 in pre- 
ferred stock and $33,500,000 in common stock; $61,000,000 
in all. The earning power of the two companies which had 
been combined amounted, however, to about $3,500,000, and 
there was thought to be reasonably good prospects for growth 
m these earnings. On the strength of these earnings the capi- 
talization was regarded as perhaps somewhat excessive but 
not abnormal. As a matter of fact, the company later failed 
disastrously, due in part to the overestimates that had been 
made of its earning capacity. 

A striking example of sudden variation in earnings quickly 
followed by readjustment of capital is furnished by the Sub- 
marine Boat Corporation. This corporation was originally 
known as the Electric Boat Company, and for many years was 
regarded as practically a failure. It had an authorized capital 
of $5,000,000 common and $5,000,000 preferred, of which 
$4,999,600 common and $2,667,500 preferred were outstand- 
ing. The company's business was to build submarines for 
which it held valuable patents, and also high-powered gasoline 
launches which may be used as submarine destroyers. After 
it appeared that the submarine was to become a highly im- 
portant factor in the European conflict, it quickly became 
evident that the Electric Boat Company was in a position to 
reap enormous profits from the situation. As late as the winter 
of 1 9 14, the common stock was quoted at a nominal price, 
around $10 a share; by the fall of 191 5 it had risen to over 
$480 a share. During this rise, Isaac L. Rice, the organizer 
and long the chief manager of the company, sold his shares, 
which were taken over by a syndicate that arranged to recapi- 
talize and for this purpose formed the Submarine Boat 
Corporation. 

The shares of stock of the new corporation were issued 
without par value and for this reason it is impossible to 
cite exact figures showing the extent of the recapitalization. 



186 CAPITAL 

However, on the basis of the quoted boat shares, the new 
capitalization of the Submarine Boat Corporation may be 
figured as having a market value at the beginning of $35,- 
000,000. 

There is surely little doubt in the mind of any one who 
is familiar with such occurrences, as to the truth of the general 
statement that capitalization tends very strongly to conform 
itself to earnings rather than to actual investment. 

Estimates of Earning Power 

In what has been said in the preceding section as to adapt- 
ing capitalization to earning power, it has been assumed that 
there will be no difficulty in determining earnings. If a com- 
pany has been doing business successfully over a period of 
years and has had reasonably stable earnings, it would seem 
that there ought to be little difficulty in estimating the proba- 
bilities for the future; yet the experience gained during the 
last 15 or 20 years in forming combinations of industrial com- 
panies indicates quite clearly that even expert estimates are 
an unsafe guide. 

At the time the American Malting Corporation was formed 
in 1897, a preliminary examination of the 22 plants concerned 
was made by an accountant of high standing, who reported 
that these concerns had earned about $1,300,000 per annum 
during five years of depression, and that the net earnings 
under a combination should be at least $2,000,000 without 
raising the price of the product to the consumers. Unfor- 
tunately, in making this estimate one important factor was 
overlooked. The business of furnishing malt to brewers had 
been an affair largely of financial connections and personal 
friendships. The brewers preferred to deal direct with the 
heads of the concerns from whom they bought their malt and 
refused to take kindly to the more businesslike methods of 
the "trust." As a result, the combination, instead of gaining 



BASIS OF CAPITALIZATION j%y 

through the greater efficiency of its sales methods, actually 
lost ground. The whole transaction, it has been remarked, is 
"a startling illustration of the fallacy of basing an estimate 
of the future earnings of a consolidated company upon the 
aggregate earnings of the constituent plants prior to their 
combination."* 

In his excellent study, which is frequently referred to in 
this volume, Mr. Dewing includes a list of important indus- 
trial combinations showing the ratio between the earnings 
actually realized after the consolidation, and the aggregate 
earnings of the subsidiary companies before the combination. 
The following are his percentages: 

Mount Vernon-Woodberry Cotton Duck Company 166% 

National Salt Company x 34% 

New England Cotton Yarn Company 98% 

International Cotton Mills Corporation 56% 

United States Ship Building Company 56% 

United States Realty & Construction Co 50% 

Asphalt Company of America 40% 

American Malting Company 31% 

American Bicycle Company 24% 

Some of the discrepancies above shown may have been 
due in part to padded statements of earnings on the part of 
the companies which just prior to the combination were trying 
to make the best possible terms for themselves, and some are 
due, doubtless, to the fact that combinations are generally 
organized at the height of a period of prosperity. In general, 
however, they seem to represent a tendency toward actual 
decline in efficiency under the new form of organization. 

Wherever the personal element in management is strong, 
estimates of future earnings are particularly uncertain. After 
a strong, going organization has been formed and methods 
have become standardized, this element of uncertainty due to 

*Dewing's "Corporate Promotions and Reorganizations," p. 273. 



T SS CAPITAL 

the personal factor becomes less and less prominent. Never- 
theless, in some lines of business it is especially strong. For 
example, it is reported that bankers are not willing to make 
large advances to companies engaged in operating chain stores. 
They believe that these stores depend to an especial degree 
upon the human equation. A single mistake in buying on a 
large scale might result in serious loss, for these stores gen- 
erally sell on a close margin of profit. The death of the 
executive who had built it up and had formed his personal 
connections might be a fatal blow. 

Another source of uncertainty in lines of business where 
earnings would otherwise be remarkably stable, consists in 
the legislating power of governmental bodies. The legisla- 
tures of several states have in recent years passed laws fixing 
rates of transportation and of public utility services on arbi- 
trary bases which have introduced a sudden and wholly un- 
foreseeable change in the earnings of the corporations affected. 
There is probably no reasonable ground for doubting that 
this is a wrong principle. Wherever profits require regula- 
tion, it should certainly be carried on by some systematic and 
continuous method. In Great Britain there is no such thing 
as public rate regulation as understood in America. The two 
methods of regulation are the maximum dividend method and 
the sliding scale method, both of which operate continuously 
and automatically. 

There is, perhaps, no safe practical rule to follow in mak- 
ing or in reviewing estimates of future earnings, except to 
follow the rule of skepticism. Sometimes the skepticism may 
be undeserved, but at any rate the banker or investor can make 
no mistake in demanding full and satisfactory evidence of the 
correctness of the estimates. This remark applies especially 
to promoters' estimates of the future profits of their concerns. 
"When you are capitalizing a perhaps which you believe to 
be infinite," says Hartley Withers in one of his incisive 



BASIS OF CAPITALIZATION igg 

epigrams, "the number of noughts that you add on to the 
market value of the company's capital is a matter that does 
not concern you as long as you are wrought up to the right 
pitch of excitement. "* 

Adjusting Capitalization to Assets 

It is plain, from what has been said above that many 
corporations, either at the outset or at some later stage in 
their career, are faced with wide discrepancy between the 
actual value of all their assets and the nominal net worth of 
the business which is represented by capital stock. In 1897, 
for example, the Glucose Sugar Refining Company was or- 
ganized as a combination of six glucose refineries. Although 
$7,500,000, it is reliably estimated, would have fully covered 
the actual value of the plants and current assets acquired, the 
company started with a capital stock issue of $37,000,000. In 
1906 this same combination, with some additions, was reor- 
ganized under the name of the Corn Products Refining Com- 
pany, which is estimated to have had assets worth approxi- 
mately $15,000,000. Against these assets the company issued 
a bonded debt of $9,500,000, preferred stock of $30,000,000, 
and common stock of $50,000,000. 

Once in a while, if a corporation has been continually 
unsuccessful over a period of years, an effort is made to 
improve the financial status by reducing its capital stock and 
its contingent charges. This was attempted, for example, with 
the Corn Products Refining Company in 19 10, when the presi- 
dent brought out a plan which called for the absolute sur- 
render and cancellation of four-fifths of the outstanding $50,- 
000,000 of common stock; the remaining one-fifth of common 
and all the preferred stock was to be exchanged for new stock 
of one class, upon which it was proposed to pay dividends 
at the rate of 5% per year. The result would have been to 



^Hartley Withers on "Stocks and Shares," p. 287. 



190 



CAPITAL 



cut down the charges against the company and to make up 
a much better-looking balance sheet. However, the preferred 
stockholders saw no advantage to themselves in giving up part 
of their claims and the plan eventually failed. 

A similar process is much more frequent in English prac- 
tice. In November, 19 14, a circular letter was sent out to the 
preference shareholders of R. White and Sons, in which the 
directors stated that they had had fresh valuations made of 
the assets which had disclosed a total value less than the book 
value of these assets, amounting to £87,760. The directors 
were also anxious to eliminate from the balance sheet the 
large "good-will" item which amounted to £94,367, and 
thought it wise to write off a further sum of £7,500 against 
other assets. These three sums together amounted to £189,- 
627. The directors' proposal was to charge £25,627 against 
Reserves and Profit and Loss accounts, leaving £164,000 still 
to be dealt with. This was offset by reducing the nominal 
value of all the outstanding ordinary shares from £3 to £1 
each. The ordinary shareholders made it a condition of their 
agreement to this arrangement, that they should be entitled 
to the same aggregate amount of dividends on their shares 
as they were previously entitled to before contributions were 
made to the special reserve. That is to say, where they were 
previously entitled to 5%, they were, after the change, en- 
titled to 15% on the reduced capitalization. 

To the average American mind all the complexities and 
niceties of a transaction such as the one just described, seem 
like so much useless juggling with figures. The purpose of 
any well-managed company is to make profits and distribute 
them according to the various claims against these profits that 
are outstanding. Whether the ordinary stock is listed at a 
nominal value of $82,000 or $246,000; whether "good-will" 
stands at $94,000 or at nothing, and similar questions of 
academic accounting, have very little apparent connection with 



BASIS OF CAPITALIZATION l g 1 

changing the business from a profit-loser into a profit-maker. 
The typical English financial manager attaches vastly more 
importance than does the typical American financial manager, 
to presenting a balance sheet that makes an impression of 
stability and conservatism. Doubtless there is much to be 
said on both sides. It is enough here merely to call attention 
to the variation in practice. 

It is sometimes thought to be desirable by the directors of 
a corporation to have the corporation purchase some of its 
own outstanding stock, which is, in effect, a method of reduc- 
ing its capitalization. The general rule of the law, which 
applies with modifications in almost all jurisdictions, is to the 
effect that a corporation may purchase its own shares only 
out of surplus. It cannot, in other words, carry the purchase 
of its own shares so far as to produce a deficit which might 
be injurious to creditors. 

Valuation of Good-will 

The law assumes that the assets of a corporation are valued 
at cost and that, after the deduction of liabilities, the remain- 
ing equity in the assets is represented by capital stock. 

The truth of the case is, as we have seen, that capitaliza- 
tion — at least for the companies with marketable securities — 
is determined on the basis of earning power, and that the 
book valuation of a company's assets is then adjusted to the 
capitalization. This makes the valuation of assets for account- 
ing purposes, in part at least, an arbitrary process. Whenever 
it is not thought desirable to place a purely arbitrary value 
upon tangible assets, or whenever the capitalization is so large 
that any arbitrary value within reason will still leave a gap, 
then we have "Patents," "Copyrights," "Organization," 
"Good-will," or some other intangible asset entered upon the 
books and appearing in the balance sheet at a valuation suffi- 
cient to offset the nominal value of outstanding capital stock. 



192 



CAPITAL 



As an illustration, take a case, which came to the writer's 
attention some years ago, of a company publishing a well- 
known popular magazine, which had issued stock only for an 
equivalent amount of cash paid in. The magazine had out- 
standing $300,000 of common stock; had assets over and 
above the liabilities (except stock) of approximately $250,000; 
and showed also on the asset side of the balance sheet an 
accumulated deficit of practically $50,000. Its balance sheet 
in this highly condensed and simplified form would appear 
as follows: 



Assets 

Net Capital and Current 

Assets $250,000.00 

Accumulated Deficit.... 50,000.00 



Total $300,000.00 



Liabilities 
Capital Stock.... $300,000.00 



$300,000.00 



Just about the time when the magazine had reached this 
stage and its proprietors were greatly discouraged, it started 
to run a series of feature articles which suddenly became 
immensely popular. The circulation and advertising receipts 
suddenly jumped to figures previously unthought of. In the 
first year after this sudden change of fortune, the corporation 
earned profits of approximately $40,000, and the directors 
desired to distribute dividends of $30,000. But there was no 
surplus out of which to declare dividends; on the contrary, 
the balance sheet still showed an impairment of capital which 
must be made up before dividends could legally be declared. 
In this predicament they called in an experienced accountant 
who solved the difficulty by directing that a very simple entry 
be put into the company's journal, debiting a new account to 
be called "Good-will" to the amount of $100,000 and crediting 
Surplus for a like amount. Thereafter the company's balance 
sheet in its highly simplified form, appeared as follows: 



BASIS OF CAPITALIZATION 



193 



Assets 

Net Capital and Current 

Assets $290,000.00 

Good-will 100,000.00 


Liabilities 

Capital Stock $300,000.00 

Surplus 90,000.00 






Total $390,000.00 


$390,000.00 



There was then nothing to prevent the immediate distribu- 
tion of cash profits in the form of dividends.* 

Good-will is not necessarily valued in quite so arbitrary 
and casual a fashion. Where a corporation has accumulated 
out of earnings a substantial surplus, and where there is gen- 
uine good-will which it is desirable to show in one form or 
another in the balance sheet, a careful valuation may be made. 
For example, a case of this nature arose in connection with 
the appraisal in September, 19 14, of the estate of the late 
Joseph Pulitzer, former proprietor of the New York World 
and of the St. Louis Post-Despatch. The appraiser, first of 
all, made a careful estimate of the earning power of each one 
of the newspaper properties. For this purpose he took the 
average annual earnings of each corporation for four years 
preceding Mr. Pulitzer's death. From this average figure, 
however, he deducted a considerable sum by reason of certain 
very favorable contracts for the purchase of white print paper 
which were about to expire, and he further deducted $100,000 
as being a reasonable estimate of the value of the services of 
Mr. Pulitzer himself. He deducted, also, 6% on the actual 
capital invested. This left average net earnings of $196,411 
for the St. Louis Post-Despatch, and $81,180 for the New 
York World, both of which the appraiser capitalized on a 
10% basis, making his valuation of the good-will of the first- 
named paper $1,964,110, and of the second-named paper, 
$811,800. 



*The case just cited is actual but the figures have been much changed in order 
to simplify the statement and to avoid identification. 



194 CAPITAL 

The above case is one of the most important precedents 
for methods of valuing good- will that have been established 
in this country. In England it is customary to calculate the 
good-will as the present worth of the profits from three to 
ten years ahead, the length of time depending upon the sta- 
bility and transferability of the business. 

The following remarks on this point were made by the 
writer in connection with an inquiry as to how to determine 
the value of an insurance agency business : 

Having arrived at the value of all the other assets 
of an insurance agency, i.e., furniture and fixtures, 
insurance in force, real estate, etc., it would then be neces- 
sary to estimate the worth of its insurance business itself. 
The personal equation plays a great share in agency 
insurance, and the withdrawal of the man or men who 
have been actively identified with the establishment and 
with the running of the agency is likely to affect seriously 
the earnings of the concern, especially if the business 
has been confined to a particular locality, which is often 
the case. There is also to be considered the value which 
attaches to its sub-agency force as well as the volume 
of business the agency is doing, since the rates of com- 
mission paid by the insurance companies and the credits 
extended by them in the collection of premiums are by 
no means uniform. An additional point to be considered 
is that in many instances insurance agents also act in 
the capacity of adjusters in fixing losses of their clients. 
The earnings from this source are often not to be found 
on the books of insurance agents, and it is an item to 
be considered. 

Having in mind all these factors, the test to be applied 
in determining the worth of the business itself is: 
How much earning power could be transferred to other 
individuals who might take over the business? Capitalize 
this earning power at whatever rate is agreed upon, say 
15%, and you have the transferable good-will of the 
business. 



BASIS OF CAPITALIZATION 



195 



In this discussion, no attempt has so far been made to 
give an accurate definition of the vague term "good- will." 
It is, in fact, almost incapable of definition for the reason that 
it is continually used in many varying senses. The term arose 
undoubtedly in connection with retail trade and with profes- 
sional practice, where it referred to the habit that had been 
established on the part of many people who were accustomed 
to trading with a good shop or with an established profes- 
sional practitioner. Experience has shown that this habit will 
continue to carry people to a shop or to a physician's or 
lawyer's office even after the original proprietor or practitioner 
has withdrawn. The vendor of a business or a practice of 
this nature usually contracted, for a given consideration, to 
recommend his successor and thus literally sold to him his 
"good-will." As it is used in a great majority of present-day 
transactions, the term has little perceptible relation to its 
original meaning.* 

When a modern corporation transfers good- will or enters 
good-will upon its books, the asset which is thus represented 
consists of something even more intangible than the kind of 
good- will that accompanied the sale of the little retail shop. 
A corporation's "good-will" may consist in part of established 
trade and of the habits of people who desire to buy its prod- 
ucts; it may consist in part of having created an efficient, 
smoothly working internal organization; it may consist in 
part of having driven off all rivals and monopolized its field; 
it may consist in part of well-known trade-marks or of 
patents. An adequate definition of "good- will" in its modern 
sense must cover all the above and many other similar varia- 
tions of intangible assets. The one definition which seems to 
the writer to cover everything is this : Good-will is the capi- 

*The classical definition of good-will, according to Withers, was contributed by Dr. 
Johnson, when, as executor of a friend's estate, he assisted at the sale of a brewery 
to two Quaker gentlemen. Being asked to place a value on the real assets, he replied: 
"We are not here to sell a parcel of boilers or vats, but the potentiality of growing rich 
beyond the dreams of avarice." 



196 



CAPITAL 



talization of that portion of the earning power of a business 
which is not credited to other assets. 

With this definition in mind, the question as to the right 
method of valuation of "good-will" in any given case is sim- 
plified. It is necessary to follow the same method that was 
used by the appraiser of the Pulitzer properties, that is, to 
eliminate from average earnings those which are to be ascribed 
to the ownership of tangible assets or to temporary causes; 
the remaining earning power may then be capitalized on what- 
ever basis is suitable for the business under consideration. 
In some lines of business this percentage might be as low as 
6 or 8% ; in others 10%, and in others 12, 15, and even 20%. 

The definition just suggested carries with it a ready ex- 
planation of the fact that "good- will" is a much more per- 
manent asset in some lines of business than in others. Those 
lines of business which employ an overwhelming proportion of 
fixed capital assets, ordinarily attribute their earnings almost 
wholly to these assets, and there is seldom a'hy occasion for 
entering such an item as good-will. On the other hand, those 
corporations that are engaged chiefly in trading, their earnings 
being dependent to a great extent upon the rapidity of their 
turnover or upon popular favor, may find, if they are suc- 
cessful, that their earnings mount far beyond any sum that 
can reasonably be attributed to their capital assets. 

In this latter class belong such concerns as the F. W. Wool- 
worth Company, with its great chain of 5 and 10-cent stores, 
which carries a Good-will account of $50,000,000. Many 
publishing companies quite properly carry good-will as one of 
their most important assets. The Butterick Company, out 
of total assets of $19,236,467, has $9,786,065, or over one- 
half, included under the heading "Patents, Good-will, Con- 
tracts, Copyrights, Trade-marks, etc." Messrs. Silver-Burdett 
and Company carry "Publishing Rights, Contracts, Copy- 
rights, etc.," at $1,024,820 out of total assets of $1,944,665. 



BASIS OF CAPITALIZATION 197 

There are many cases, also, where highly profitable and rapidly 
growing companies may have trouble in valuing their assets 
at a figure high enough to offset the amount of stock which 
their directors feel should properly be outstanding. This is 
the case, for instance, with the Hendee Manufacturing Com- 
pany of Springfield, Mass., which on August 31, 19 14, carried 
a Good- will account of $8,300,000 out of total assets of $13,- 
367,502. The American Chicle Company carries "Good-will, 
Trade-marks, etc.," at $8,128,607 out of total assets of $13,- 
592,997. In spite of this enlarged capitalization, the company 
has paid 18% dividends on its common stock regularly since 
1907. On the other hand, the highly successful and long- 
established Eastman Kodak Company, which is paying div- 
idends that average over 40%, and is earning in the neighbor- 
hood of 70% on common stock, does not carry a cent of 
good-will or other intangible asset accounts. 

Recapitalization by Stock Dividends 

In cases where surplus has accumulated with great rapidity, 
it is more and more customary for the corporation to recognize 
this accumulation by issuing new shares in the form of stock 
dividends. As has been previously explained, this procedure 
does not necessarily mean increased cash returns to the stock- 
holders and does not affect their relative interests in the cor- 
poration, but it is convenient and helps to increase the market 
value of the stock. In recent years, some of the motor com- 
panies which have been highly successful have declared no- 
table stock dividends. The Chalmers Company, for example, 
was incorporated in 1908 with a capital stock of $300,000; 
two years later the directors declared a stock dividend of 
900%, making the capital stock $3,000,000. In October, 191 2, 
they declared another stock dividend of 33 1/3 %, making the 
outstanding common stock $4,000,000; and in June, 1913, 
another dividend of 25% was declared, making the outstand- 



1 98 



CAPITAL 



ing stock $5,000,000. Since June 1, 191 1, cash dividends on 
the common stock have been paid at the rate of 10%. In 
191 5 the Ford Motor Company was said to have had under 
consideration a stock dividend of 2400%, increasing its out- 
standing capital stock from $2,000,000 to $50,000,000, but on 
account of some legal difficulties the plan, up to this writing, 
has not been carried through. 

Other manufacturing companies have also had remarkable 
stock dividend records. Up to 1900 the capital stock of the 
Singer Manufacturing Company was $10,000,000, and that 
year a stock dividend of 200% was declared, making it $30,- 
000,000. In 19 10 another stock dividend of 100% was de- 
clared, making the capital $60,000,000. During all this period 
cash dividends have been high. In 1899, J ust before the 
first-named stock dividend, cash dividends were 100% ; in 
1904 and again in 1909 they were as high as 30% ; since the 
stock advance of 19 10 they have been averaging 12 to 14%. 
Swift and Company originally had a nominal capital of $300,- 
000, which has been increased at various times to $3,000,000, 
$5,000,000, $7,500,000, $15,000,000, $20,000,000, $25,- 
000,000, $35,000,000, $50,000,000, $60,000,000, and finally 
$75,000,000. 

Attention has already been called to the possibility of 
avoiding constant changes in capitalization — which are always 
of an arbitrary nature — by the use of shares without par value. 
It would be theoretically possible to have no shares whatever 
outstanding, and there is one case on record of an English 
enterprise known as the Undertakers of the Aire and Calder 
Navigation and Steamship Company, which until 1895 na< ^ 
no shares. The capital was bought and sold at so many years' 
purchase of the dividends. The modern arrangement, how- 
ever, is to have shares bearing no par value. A law authoriz- 
ing the issue of shares without par value was adopted in New 
York State in 1912! 



BASIS OF CAPITALIZATION 



199 



Capitalization of Public Service Companies 

The assumption which has been made throughout this 
chapter that capitalization may be rightfully adjusted to what- 
ever figure within reason the organizers or directors of a 
corporation may think proper, applies to manufacturing and 
trading companies, but does not apply to financial companies 
or to most public utility companies. Financial companies are 
in this respect in a class by themselves, for the reason that 
they are themselves dealers in cash and in credit and it is 
essential that their financial position should be at all times 
clear and easily ascertainable ; consequently, they do not enter 
good- will on their accounts, not because it does not frequently 
exist, but because to do so would involve questions of judg- 
ment and of motive which they cannot afford to have raised. 
For that reason their balance sheets ordinarily show only 
assets the value of which can readily be determined by ex- 
amination, and as to which no debatable question is likely to 
arise. 

The case with public utility companies differs because of 
public sentiment which has been aroused against "overcapi- 
talization," which is believed by many people to be injurious. 
In this respect the English practice is even more severe than 
in this country. The policy of Parliament and also of the 
Board of Trade of the United Kingdom has been to grant 
power to railway and tramway companies to raise an amount 
of capital estimated to be sufficient for their immediate re- 
quirements; in granting capital powers to gas companies, the 
Board of Trade usually endeavors to estimate the require- 
ments of the company for a term of 12 to 15 years. It is 
clear that the intention is to maintain a strict governmental 
control and to see to it that every cent of capital is represented 
by a corresponding amount of cash or of assets purchased 
with the shareholders' cash. In the United States, public 
service commissions are following much the same policy. In 



200 CAPITAL 

New York State the output of stocks and bonds by utility 
corporations is carefully regulated to such an extent that it 
has proved really a difficult matter in some instances to secure 
permission to obtain capital that was urgently needed. For 
some years there has been agitation to apply the same prin- 
ciples of regulation to interstate railroads, but no definite 
action has as yet been taken. 

We may conclude, then, that in general the capitalization 
of public utility companies is more strictly in accord with the 
legal theory of a correspondence between capitalization and 
capital assets than is true in other forms of enterprise. Public 
utility companies are among the enterprises above referred to, 
the earnings of which can generally be attributed almost 
wholly to their tangible assets. As a practical matter, there- 
fore, it is not inconsistent with the practice of most of the 
well-managed companies to require that they should issue 
capital stock only for the purpose of acquiring cash or tangible 
assets fully equivalent to the nominal value of the stock. 



Part III — Securing Capital 



CHAPTER IX 

SOURCES OF CAPITAL FUNDS 

Capital Funds 

The typical corporation starts in much the same way as 
the typical partnership — through an agreement on the part of 
two or more men who are acquainted with each other, to join 
forces in a business enterprise. In a partnership, these men 
sign a formal partnership agreement and pool part or all of 
their capital and other resources; in a corporation they mu- 
tually agree upon the amount of capital required, the amount 
of capital stock to be authorized, and the issuance of the stock 
for cash, property, and services. No matter which financial 
form is adopted, the essential fact common to both is that the 
money and the business ability required for the enterprise are 
both supplied by the same group of men. 

As the corporation expands — assuming that it is a success 
— and fresh capital is needed, it may come in whole or in part 
from the same group of men. In case their capital has been 
exhausted or is otherwise tied up, the next move, frequently, 
is to find some other man who has capital to invest and at the 
same time will be a valuable addition to the executive staff 
of the business. Some concerns keep on growing in this way 
for a long time. Other concerns — by far the vast majority — 
soon attain their normal volume of business and thereafter 
need little if any fresh capital. In both these cases, the source 
of capital plainly is the man or group of men who are them- 
selves active in the management of the business. 

201 



202 SECURING CAPITAL 

A second source of capital, which usually operates in con- 
nection with the source just named, consists of savings out of 
the profits of the business. Practically every concern saves 
and adds to its permanent capital a portion of its profits. In 
corporations which are owned by the people active in the busi- 
ness, the tendency is strong toward putting a large proportion 
of the profits back into the business. The active men realize 
the needs and the possibilities in the business better than out- 
side stockholders could possibly do. Sometimes they are 
willing to put back practically all the profits and to keep up 
this policy over a period of years. The enormous capital of 
the Carnegie Steel Company was, for example, almost wholly 
built up by this method. Much the same thing is true of the 
Winchester Arms Repeating Company and of many other 
closely held and highly successful concerns. A conspicuous 
recent example of the great results which may be achieved 
by the patient saving and reinvesting of good profits over a 
series of years, is the Bethlehem Steel Corporation. 

Most companies that are successful on a large scale reach 
the point, in the course of a few years, where more capital is 
needed than can possibly be supplied by the people who are 
directly engaged in handling the business. Some corporations, 
as we shall see, reach this stage at the very beginning; that is 
to say, they start full blown as publicly owned enterprises. 
They are, however, exceptional. Whenever it is necessary to 
go outside the group of men who are directly connected or 
directly familiar with the enterprise, the capital may be said 
to be raised from the public at large. For our purpose we 
may divide this public — as is customarily done in nearly all 
writing or thinking on financial subjects — into two fairly 
distinct groups— those who invest and those who speculate. 
The investing public consists of the people who are more con- 
cerned over getting back their principal than they are over 
making profits. The speculative public consists of those who 



SOURCES OF CAPITAL FUNDS 203 

are chiefly concerned in making profits, and for this purpose 
are willing to accept more or less risk with the principal. It 
has previously been noted that distinct types of security issues 
are designed to appeal to these two groups. There is, of 
course, no sharp dividing line. 

So far as the issuance of securities is concerned, there is 
little to be said at this point in connection with the first and 
second sources of funds named above — persons close to the 
business and the profits of the business. Some attention must 
be given, however, to the forms of securities that should be 
selected if an appeal is to be made to the third source, the 
investing public, or to the fourth source, the speculative public. 

The Investing Public 

The word "public" suggests a large crowd of individuals, 
and the term "investing public" may easily call up a vivid pic- 
ture of thousands of staid and prosperous persons who per- 
sonally tuck away their own bonds in their strong boxes and 
whose chief labor consists in cutting off the coupons. This 
picture is to a certain degree true of the purchasers of those 
investments which have a slightly speculative tinge, such as 
bonds that sell on a basis of 5^2% or more. John Moody, 
however, is authority for the statement that the "gilt-edge" 
investment securities are taken chiefly, not by individuals, but 
by institutions. These securities sell on the basis of, say, 3% 
to 5J^%, and the individual investor is much more apt to be 
a contributor in some way to the support of these large invest- 
ing institutions, rather than a direct purchaser of this type of 
securities. 

Banks and Institutions 

First among the institutional investors, we find banks. 
Savings banks are enormous purchasers of the highest grade 
bonds. Under the laws of most states their purchases are 



204 



SECURING CAPITAL 



clearly restricted to bonds of a certain approved class which 
are frequently referred to in Wall Street as ''savings bank 
bonds." Commercial banks, also, from time to time take^ 
large quantities of investment securities, chiefly short-term 
obligations. Insurance companies spend a va^t amount an- 
nually in the purchase of investment securities. All institu- 
tions the funds of which are held in trust, such as universities, 
philanthropic institutions, and the like, must confine themselves 
strictly to investment securities. Estates of deceased persons, 
administered in trust, are large purchasers. 

Institutions, then, constitute the public to which the highest 
grade investment securities must be sold. Individuals handling 
their own funds are free to exercise their discretion and take 
whatever slight degree of risk there may be in the purchase of 
securities that do not comply with the strict terms of the laws 
covering institutional investment. 

It will be readily seen that there are noteworthy advan- 
tages to the corporation which can adapt any important part 
of its securities to the requirements of institutional invest- 
ment. First of all, such securities are in high demand and sell 
at excellent prices. Second, they are likely to "stay put" after 
they are sold. The institution ordinarily does not die or become 
hard up or easily panic-stricken ; consequently, securities which 
it has once purchased are likely to remain with it until they 
mature. Throughout the crisis in the affairs of the New 
Haven Railroad Company in 191 3- 19 14, the debentures of the 
company, which were closely held by insurance companies and 
savings banks, did not to any great extent come on the market. 

Investment Associations 

In other countries even those individual investors who in 
this country would buy securities direct are apt to efface them- 
selves as individuals and join investment trusts or investment 
associations. These associations are common in Great Britain, 



SOURCES OF CAPITAL FUNDS 205 

France, and Holland, and are not uncommon in other coun- 
tries. The investment associations frequently sell their own 
bonds as well as their own shares. They take the money thus 
obtained and invest it in securities of other corporations. 
What is the advantage, it may be asked, of this indirect method 
of investing? 

The great advantage is that the uninformed judgment of 
the individual who purchases only a few stray securities from 
time to time, is replaced by the trained and experienced judg- 
ment of men well acquainted with investment securities and 
the investment market. This at least is the theory of the situ- 
ation. There is another advantage, also, in the fact that, in- 
stead of having available for investment only the small savings 
of individuals, the investment association deals in large sums 
and is therefore in a position to buy advantageously. Further- 
more, on account of its large purchases it can distribute its 
risk over a wide field. Its securities, for instance, would not 
all be bought in one country but in several countries; they 
would not all be in one or two lines of business, but in several 
lines, and so on. This principle of the distribution of risk is 
the most practical form of insuring the safety of the invest- 
ment that has yet been brought forth. The investment associa- 
tions, as a rule, are managed with skill and ability and in the 
long run make money; though there are, of course, some un- 
fortunate exceptions. 

Speculative Public 

The purchasers of speculative or even semi-investment 
securities are, with negligible exceptions, individuals. The 
term "semi-investment" in this connection is applied to such 
securities as high-grade preferred stocks and junior bonds, 
which are customarily regarded as reasonably safe but which 
are subject to a greater degree of fluctuation and uncertainty 
than the strictly high-grade investments. There is a fairly 



2 o6 SFXURING CAPITAL 

clear three-fold division of the immense number of purchasers 
and possible purchasers of speculative and semi-investment 
securities : 

i. The buyers who have in view primarily the safety of 
their principal, in which they do not anticipate any great ap- 
preciation in value, but who desire a larger rate of return than 
can be obtained from strictly investment securities. These are 
the purchasers of junior bonds, preferred shares, and the like. 

2. The purchasers who are looking primarily for an in- 
crease in the value of their principal, though they do not 
object, naturally, to a high percentage of yield. These are 
the purchasers of common shares, especially those which are 
not so thoroughly seasoned as to approach the semi- 
investment grade of securities. The members of this group 
are likely to be for the most part people who have some especial 
connection with, or interest in, the corporation, the shares of 
which they are purchasing; often they are minor officers or 
employees of the corporation. 

3. The speculators on margin, who operate on the Wall 
Street and other stock exchanges. A large number of them 
are merely gambling; others have some special information 
as to a given corporation the shares of which are listed on 
the stock exchange, and are trying to make capital out of their 
information. Still others are observers of general market 
conditions, and buy and sell standard issues with little regard 
to their intrinsic value, but with a great deal of regard for 
the buying and selling movements on the exchange which they 
see in progress. 

Some of the details in this rough outline sketch will be 
filled in later when studying methods of selling security issues. 

Wide Distribution of Shares 

A remarkable feature of the last ten or fifteen years in the 
United States has been the widening distribution of the shares 



SOURCES OF CAPITAL FUNDS 



20/ 



of large corporations, indicating that a greater and greater 
number of people who possess or can save capital are putting 
their money into corporate securities. Taken in the aggregate, 
the size of the speculative public in the United States is enor- 
mous. The Wall Street Journal calculates that 327 large cor- 
porations in 19 1 3 had a total of 1,251,468 shareholders listed 
on their books. Even after making a liberal allowance for 
duplications, the number is strikingly large. Many of the 
stockholders are small. The 327 corporations analyzed have 
a combined share capital of $12,871,327,450. The average 
holding of railroad shares is $13,320; of industrial shares, 
$8,500. For industrial shares the average holdings in recent 
years are as follows : 

1901, $22,000 191 1, $10,000 

1906, 14,000 I 9 I 3' 8.500 

The United States Steel Corporation has over 124,000 
shareholders of record, among whom are included many for- 
eign investment associations and other holders who are prac- 
tically trustees for a considerable number of other people, 
so that the total number of persons financially interested in 
the United States Steel shares is thought to be about 150,000 
to 160,000; 40,000 of the shareholders are its own employees 
and they constitute about one-sixth of the total number of 
employees of the corporation. In 1901 the average holding 
of United States Steel shares was $32,000; in 1906, $15,000; 
in 1913, $7,000. The average holdings of other important 
companies compare as follows : 

1901 1913 

American Telephone & Telegraph Co. $14,105 $6,400 

American Radiator Company 30,800 8,700 

. American Tobacco Company 3,3,7°° 14*185 

. . Burroughs Adding Machine Company 24,000 24,000 . 

Borden's Condensed Milk Company 367,646 10,630 

General Electric Company 6,900 7400 

United Fruit Company 7,5°° 4.842 



2 o8 SECURING CAPITAL 

It is clear from all these facts, that the most successful 
and most popular corporations are carefully cultivating the 
good-will of the owners of small amounts of capital, including 
their own employees, and that a notable transfer of ownership 
into the hands of a larger number of people is in process. 
This does not, for the present, necessarily mean a transfer of 
control, which is usually safely in the hands of a few large 
holders of shares. Yet it involves some tendency at least 
toward corporate democracy, both in the ownership and in 
the control of large corporations. 

Selling Shares of Smaller Corporations 

From this same source, the speculative public, must come 
the capital of small enterprises. After an enterprise has passed 
the stage in which the capital is furnished by those directly 
engaged in the enterprise, if the business itself is worthy and 
sufficiently profitable, there is no good reason why it should 
ever fail from lack of sufficient capital. The difficulty in most 
instances where needed capital is not obtained, consists in 
the very common delusion that the capital is to be sought far 
away from home. When one of the enormous, nationally 
known corporations, with years or perhaps generations of 
success behind it, desires to obtain some millions of dollars of 
fresh capital, its officers enter into a contract with some bank- 
ing firm which undertakes to furnish the capital and which in 
turn disposes of the securities of the corporation among its 
own clientele. This is the big-scale method of raising fresh 
capital from the speculative public. The actual work of sell- 
ing the corporate stock is not performed by the corporation's 
officers. All that they need to do is to make the right kind of 
contract. Often the manager of a small local corporation 
forms the idea that he should and can raise his capital in the 
same impersonal way. He altogether forgets that his neighbor 
Jones has just sold a farm and has $10,000 lying idle in the 



SOURCES OF CAPITAL FUNDS 



209 



bank ; that his customer Smith is a good personal friend of his 
and can raise any reasonable amount of money; that his em- 
ployee Brown is building up a good-sized savings account and 
would save more and work better if he were stimulated by the 
pride of owning an interest in his employer's business. Instead 
of interviewing Jones, Smith, and Brown, with money in their 
pockets which they would willingly exchange for shares in his 
enterprise, the corporate manager of the type we have in mind 
is apt to think that some broker in a distant city could easily 
raise the $10,000 or $50,000 that is needed if he could only be 
persuaded to undertake the job. 

The best place to start in looking for purchasers of specu- 
lative or semi-investment securities of a small corporation is 
among business acquaintances of the men who are already 
interested in the corporation. After a few of these acquaint- 
ances have themselves become shareholders, they will co- 
operate in reaching other people, and so the list of prospective 
purchasers of the securities will expand in an ever-widening 
circle until the whole amount of the capital required has been 
raised. The best person to whom to turn for advice, ordinarily, 
is the most progressive banker in the community or — if it is 
a large city — the bankers best acquainted with the trade in ' 
which the corporation is engaged. It is the banker's business I 
to know the financial standing of his customers. If he is 
willing to say a good word for the enterprise, it will go a long 
way. At any rate his advice will be worth having. It may be 
safely said that any corporation which has a really attractive 
offer to make to the stock-buying public need not apply in 
vain. 

Adaptation of Securities to Market 

In previous chapters the principal forms of security issues 
— common and ordinary shares, preferred shares, income 
bonds, debentures, collateral trust bonds, mortgage bonds, and 



2io SECURING CAPITAL 

the like — have been described. The point has been emphasized 
that, while there are favored and popular forms of security 
issues, there are no invariable forms. Some kind of a 
security issue can be found that will suit both the taste and 
the pocketbook of anyone who has capital at his disposal. 
The financial manager of a business enterprise will make it 
his business to make such adaptations of the securities he has to 
offer as will best fit them for the market he is trying to reach. 
If his prospective purchasers are people of small income, he 
may find it best to issue shares of a par value of $5 or 
$10, instead of the conventional $100. At the other end of 
the scale, if he is getting out a note issue exclusively for 
sale to some of the big institutions, he will perhaps give his 
notes a par value of $10,000 or even $100,000. He will give 
reasonable attention, also, to passing fashions or popular in- 
terests. In one year convertible bonds are much talked about 
and easily sold. In another year the popular interest is 
centered largely on industrial preferred shares. In another 
year there is an unreasoning aversion, let us say, to collateral 
trust bonds. Any successful dealer in securities will advise 
that these fashions and whims on the part of the investing 
public be not ignored. 

In choosing forms of securities, unfamiliar financial 
devices are not usually favored unless they are brought for- 
ward by some individual or corporation with great prestige. 
The financial conditions at the time when the security is 
brought out must also be carefully considered. It has previ- 
ously been suggested that short-term notes have been issued 
by railroad and other corporations in the United States in 
great quantities during recent years, partly because there is 
a public preference for such notes and partly also because 
it has been hoped from year to year that the world-wide 
financial depression would give way to a better market for 
long-term issues. The wisdom or unwisdom of this course 



SOURCES OF CAPITAL FUNDS 211 

need not be here considered. The point to be made here is 
that the large corporations have been consciously endeavoring 
to adjust their security issues to current conditions in the 
security market. 

A striking example of very poor judgment in failing to 
make this adjustment is to be found in the history of the ill- 
fated Cordage combination. In April, 1893, the National 
Cordage Company had an inventory consisting of between 
$5,000,000 and $6,000,000 of binder twine, against which 
it had borrowed more than $5,000,000 from New York and 
Boston banks. While it was in this critical condition the 
crisis of 1893 became more and more threatening and some 
of the bankers notified the company that their loans must be 
at least in part repaid on maturity. On Friday, April, 28, 
1893, the shares of the National Cordage Company were 
selling at excellent prices, the preferred at 103 J4 and the com- 
mon at 61, and the credit of the company was high. The 
following morning at a special meeting of the board, it was 
decided to take care of the demands of the banks by an 
immediate offer to the common shareholders of $2,500,000 
of new preferred shares at par. This was equivalent to 
giving the common shareholders a privileged subscription of 
some slight value. Under ordinary conditions there would 
have been little doubt as to the success of this move. But 
the conditions were not ordinary. The action of the board 
was interpreted in the light of the general feeling of sus- 
picion and uncertainty as to the soundness of all corporations. 
On the following Monday a bear party attacked the National 
Cordage Company's shares and the market price of the com- 
mon fell below 50; two days later it had gone down to 36. 
Under these conditions it was, of course, out of the question 
to make a success out of the preferred stock issue. The 
banks became alarmed and demanded immediate and full re- 
payment and the company suddenly collapsed. It was one of 



212 SECURING CAPITAL 

the most surprising and spectacular insolvencies that is to 
be found in the financial history of the country.* 

Every possible measure should be taken to meet the con- 
venience of prospective purchasers in putting out bond issues 
of large corporations which enjoy an international market; 
for example, it is customary and proper to make interest 
payable at the principal cities of the various countries in 
which the bonds are likely to be sold. There are a number 
of issues of this country the interest on which may be col- 
lected in Paris, London, Berlin, or New York. 

Earnings and Security Issues 

Up to the present point in this chapter we have considered 
only the relations between security issues and the needs or 
notions of the prospective purchaser of these issues. It is, 
of course, clear that there must be a correspondence also be- 
tween the security issues and the needs of the corporation. 
The mere fact that a security of a given type is thought to 
be easily salable is not the final reason for issuing just that 
security. The corporation's interests may best be served by 
some other type of security, and it may be necessary — in fact, 
generally is necessary — to make a compromise. 

From the corporation's standpoint, the outstanding securi- 
ties should be in correct relation both to the assets of the 
corporation and to its earnings. If this correct relation — or 
an approximation to it — is not secured, then one of two un- 
desirable results must follow: either the capital required is 
secured upon terms that are more or less onerous and wasteful, 
or, on the other hand, the corporation is burdened with claims 
which it may not be able to meet and which, therefore, en- 



*Undoubtedly the National Cordage Company was in unsound financial condition, 
but it need not necessarily have gone down just at this time if it had not been for the 
imprudence of the directorate in failing to give due consideration to the general market 
conditions. It seems probable that their action was hasty and taken without proper 
financial advice. (See remarks in Dewing's "Corporate. Promotions and Reorganiza- 
tions.") 



SOURCES OF CAPITAL FUNDS 



213 



danger its continued existence. The first-named fault is 
probably both less frequent and less to be condemned than the 
second fault. 

Some conspicuous examples of wastefulness in raising cor- 
porate capital may readily be picked out. The Singer Sewing 
Machine Company, although it possesses tangible assets of 
enormous value, has no bonds or preferred shares outstanding, 
but only its $60,000,000 of common shares. The same thing 
is true of the Pullman Company which has only its one issue 
of $20,000,000 common outstanding; the Mergenthaler Lino- 
type Company with its one issue of $12,786,700 common 
stock; and the Arlington Mills with $6,000,000 in common 
stock. All these corporations could sell with reasonable safety 
— and during many years in the past could have sold — bond 
or preferred share issues by means of which capital could be 
raised at a rate considerably less than through the issue of 
common shares. All these corporations, it is true, are ex- 
ceptionally prosperous; their shareholders are well satisfied 
and perhaps would prefer the complete safety of their present 
position to the qualified safety which they would enjoy if 
prior claims ranked ahead of them. Nevertheless, it is true 
that earnings on the common shares would no doubt be con- 
siderably higher if the required capital had been obtained in 
part through bond and preferred share issues. The truth of 
the case is that the assets of all these corporations have been 
accumulated chiefly out of surplus earnings and the profits 
have been so large that there has been no occasion to depend 
upon security issues to any great extent for fresh capital. The 
objection that is here raised to their present arrangement of 
security issues is, therefore, it may be freely granted, of an 
academic nature. If these and other prosperous corporations 
which have relied wholly on common stock issues have erred 
at all, it has clearly been on the side of conservatism and 
safety. 



214 



SECURING CAPITAL 



Effect of Limitation to Common Stock 

There are other corporations, however, the business of 
which is not profitable to so remarkable an extent, and which 
have actually caused unnecessary sacrifices to their stock- 
holders by reason of a blind adherence to the policy of putting 
out only common stock. If a public utility company, for ex- 
ample, were to attempt to finance itself solely by the sale of 
common stock, the chances are that there would be very little 
money for anyone interested. The profits on such enterprises 
are comparatively limited, and the financing must be watched 
with the closest attention in order to preserve reasonably good 
earnings for the benefit of the common shares. This can be 
made clearer by a hypothetical case than by any example 
which is at hand, for practically all public utility companies 
do raise the greater portion of their capital through issuing 
obligations rather than through issuing shares. Let us sup- 
pose that a public utility corporation requires $10,000,000 
capital, and that its net earnings amount to $600,000, or 6% 
on the invested capital. Clearly this would not in itself be 
an attractive return to prospective purchasers of the common 
stock. Let us further assume, however, that $6,000,000 of the 
required capital is secured by bond issues at an average cost 
to the corporation of 5% ; that $2,000,000 is obtained through 
preferred stock or junior bond issues at an average cost to the 
corporation of 6% ; and that $2,000,000 consists of common 
stock. In that case, the annual profits would be distributed 
as follows: 

Bonds, $6,000,000 @ 5% $300,000 

Junior bonds, 2,000,000 @ 6% 120,000 

Common stock, 2,000,000 with earnings of 9% . . 180,000 

Total earnings .$600,000 

As a matter of fact, it is customary to provide all the cost 
of the tangible property of public service enterprises by i'ssu- 



SOURCES OF CAPITAL FUNDS 



215 



ing bonds up to about 75% of the cost, and preferred stock 
up to about 25%. The common stock in this case represents 
intangible assets and is secured by the promoters of the enter- 
prise as their profits. If this rule were followed in the case 
just cited, the results would be as follows: 

$7,500,000 bonds @ $% $375,ooo 

$2,500,000 bonds @ 6% 150,000 

Available as earnings on common stock 75»ooo 



Total $600,000 

Some interesting comparisons may be made among the 
railroad corporations of the United States in respect to the 
percentage of capital represented by means of bonded obliga- 
tions as compared with the capital raised through stock issues. 
Following is a list of some«of the important railroads showing 
their capitalization in stock and in bonds per mile, and the 
percentage of each form of security.* 

Pei 
Stock 

Wheeling & Lake Erie $80,567 

Erie 78,100 

Norfolk & Western 64,224 

New York Central 60,075 

Baltimore & Ohio 47,413 

Toledo, St. Louis & Western 44,346 

Union Pacific 42,364 

Lehigh Valley 42,089 

Northern Pacific 39,209 

Chicago & Alton 38,679 

W'abash 36,739 

Denver & Rio Grande 33,084 

Great Northern 29,687 

Atchison 28,418 

Chesapeake & Ohio 26,768 

Southern Pacific 26,162 

C, C, C. & St. Louis 26,094 

Southern Railway 25,574 

Illinois Central 25,013 



Mile 


Per Cent 


per Mile 


Bonds 


Stock 


Bonds 


%77fi77 


5i 


49 


110,847 


4i 


59 


54,835 


54 


46 


104,222 


37 


63 


89,892 


35 


65 


65,177 


41 


59 


43,971 


49 


51 


66,556 


39 


61 


30,789 


56 


44 


83,136 


32 


68 


49,38i 


43 


57 


51,801 


40 


60 


18,440 


62 


38 


28,712 


50 


50 


74,063 


26 


74 


60,669 


30 


70 


43,904 


37 


63 


40,306 


39 


61 


41,363 


38 


62 



'Copied from the \ew York Annalist, Tune 21, 1915. 



Per Cent 


per Mile 


Stock 


Bonds 


41 


59 


42 


58 


36 


64 


26 


74 


35 


65 


39 


61 


4i 


59 


3i 


69 


28 


72 


32 


68 


26 


74 


34 


66 


21 


79 


20 


80 


IS 


85 


10 


90 



216 SECURING CAPITAL 

Per Mile 

Stock Bonds 

St. Paul 24,042 34,418 

St. Louis South 22,647 30,834 

Seaboard Air Line 20,271 36,244 

Chicago & Eastern Illinois 20,135 58,072 

Missouri, Kansas & Texas 19,955 36,808 

Boston & Maine 18,941 30,000 

Northwestern 18,896 27,141 

Atlantic Coast Line 14,800 33,345 

Louisville & Nashville 14,586 38,376 

Minneapolis & St. Louis 12,933 27,070 

Pere Marquette 12,263 24,406 

Burlington 12,127 23,504 

Missouri Pacific 11,428 41,875 

C. R. I. & Pacific 10,126 36,604 

Frisco 9,505 55,734 

Cincinnati, Hamilton & Dayton 8,127 70,819 

The above table contains some striking illustrations of the 
second and more serious of the two faults above named. Note 
especially the high percentages of bonds in the case of roads 
which are at this writing in the hands of receivers, including 
the Cincinnati, Hamilton and Dayton; the Chicago and East- 
ern Illinois ; the Pere Marquette ; Frisco ; Chicago, Rock Island 
and Pacific; and Missouri Pacific. On the other hand, the 
sound roads, such as the Pennsylvania and the Great Northern, 
are, if anything, overconservative in their issue of bonds. 
Union Pacific, Atchison, Norfolk and Western, Reading, etc., 
show a proportion of approximately 50% bonds and 50% 
stock, which may fairly be regarded as conservative and about 
correct. Of course, the above percentages are suggestive 
only and might lead, if taken wholly at their face value, to 
strikingly wrong conclusions. For example, the Wheeling 
and Lake Erie, which is notoriously unsound financially, 
shows a proportion of less than 50% bonds out of its total 
capitalization; but this is to be accounted for, not by con- 
servatism in issuing bonds, but by reckless overissues of stock. 



SOURCES OF CAPITAL FUNDS 2l y 

Adequate Income for Common Stock Dividends 

It would be useless to give illustrations at this point of 
corporations which have transgressed the limits of prudence 
in selling their own obligations to the public, for we shall be 
dealing with such cases in the later chapters, where financial 
embarrassments, insolvencies^ and reorganizations are dis- 
cussed. It is obvious, on the face of it, that a corporation, 
like an individual, may abuse its credit. The rule of safety 
in the issuance of funded obligations requires that the cor- 
porate income shall at its minimum more than cover the 
fixed charges, including both interest payments and sinking 
fund payments if any. The rule of prudence, which should 
be regarded invariably in connection with the contingent 
charges assumed when deferred shares or income bonds are 
issued, is that the corporate income over and above all fixed 
charges must be ample, under all conditions that can reason- 
ably be anticipated, to cover these contingent charges. The 
rule of good faith in connection with the issuance and sale 
of common stock should be that the anticipated income, 
based upon the probabilities, should be ample to provide in 
addition to all fixed and contingent charges a reasonable and 
increasing return on the common shares. We may state 
this relation in tabular form as follows: 

i. Assured income should be more than enough for 
fixed charges. 

2. Additional income anticipated beyond reasonable 

doubt, should be more than enough to cover con- 
tingent charges. 

3. Additional probable income should be more than 

enough to provide a satisfactory yield on common 
shares. 

It is true, of course, that unforeseen occurrences frequently 
wreck even the soundest and most careful estimates, and 



2i8 SECURING CAPITAL 

that the organizers and financial managers of corporations 
are not always entitled to severe censure because their plans 
miscarry. They are clearly entitled to censure, however, if 
they do not make their estimate of future income with rea- 
sonable foresight and conservatism, and if, after having pro- 
cured sound estimates, they fail to observe the relations 
above referred to between earnings and security issues. 

Assets and Security Issues 

The assets of every business enterprise fall into three 
natural divisions: 

1. Fixed tangible assets, which are essential to the proper 

conduct of the business. 

2. Current assets, which consist of cash and of such 

property as can readily be converted into cash. 

3. Intangible assets, which have previously been defined 

as the capitalization of the earning power which 
cannot be attributed to the other assets. 

There is a relation between these classes of assets and the 
security issues of a corporation, which may be stated in the 
following form: 

The actual value of fixed assets (not merely the book 
value) should exceed by at least 25 to 50% the 
bonded obligations outstanding. 

The actual value of the fixed assets, plus the value of 
net current assets (after deduction of current lia- 
bilities) should at least equal, and generally con- 
siderably exceed, the outstanding preferred shares, 
income bonds, or other shares bearing contingent 
charges. 

The actual value of tangible assets, plus the actual value 
of intangible assets, should not exceed the value of 
the common shares outstanding. 



SOURCES OF CAPITAL FUNDS 2 IO, 

Quite a large number of industrial corporations have fol- 
lowed the principle of issuing bonds and preferred shares up 
to the net value of their tangible assets, and issuing common 
shares exactly equal to the value of their intangible assets. 
Cluett, Peabody and Company, the well-known manufacturers 
of collars and shirts, carry an account called ' 'Good-will, 
Patent Rights, Trade-Names, etc," of $18,000,000, against 
which the corporation has outstanding $18,000,000 of com- 
mon stock. The F. W. Woolworth Company, has good-will 
$50,000,000, and common stock $50,000,000; the Kaufman 
Department Stores, Inc., of Pittsburg, carries "Good-will, 
Trade-Marks, Contracts, and Leases" at $7,500,000, and has 
outstanding common stock of $7,500,000. The George A. 
Fuller Company at its incorporation in 1901 presented a 
balance sheet showing net quick assets of approximately 
$5,000,000 and "Tools, Machinery, and Good-will" of 
$10,000,000; $5,000,000 of preferred and $10,000,000 of 
common stock were issued. 

In most other cases the correlation between the different 
forms of securities and the three classes of assets is not so 
direct and readily visible. But there is, or should be, some 
measure of relation. We shall find further illustrations both 
of acceptance and of rejection of this principle as we proceed. 

Special Provisions and Forms of Securities 

As has been previously stated, there may be any number 
of forms of security issues. The more important types have 
been described in previous chapters, but a few examples may 
be cited here of instances in which it was desirable to make 
unusual changes in order to adapt the security to peculiarities 
in the assets or in the market conditions. English practice 
runs very strongly toward the issuance of perpetual or 
irredeemable debentures, the idea being that all the debtor 
cares for is to have his interest paid regularly, thus giving 



220 SECURING CAPITAL 

him a security which is readily marketable. Even the large 
brewing companies in England, which can hardly be thought 
to have a business that is beyond all human vicissitudes, have 
nevertheless issued and sold a large number of these perpetual 
debentures. In America they are practically unknown and 
would probably be almost unsalable. In the United States a 
peculiar security was brought out by a large distilling com- 
pany some years ago, consisting of a preferred stock issue 
which was, however, to be redeemed by the corporation and 
was secured by a first lien on all the whiskey stored in bond. 
It was further provided that the holder of a share of pre- 
ferred stock could, if he chose, take a barrel of whiskey in 
payment of his claim. Even this ingenious arrangement, 
it is understood, did not bring about the success of the issue. 

There has been very little real planning in the financial 
development of most corporations. The easy and obvious 
thing to do is to meet each financial difficulty or problem as 
it comes along, in the hope that there will be no further 
problems. Frequently the result is to create a maze of con- 
flicting claims, and to impose obligations upon the corporation 
which seriously interfere with the normal growth of its credit 
and lead to loss or even to insolvency. 

The financial troubles which frequently come to concerns 
that are fundamentally sound and prosperous are wholly 
unnecessary. They could be avoided by a moderate amount 
of foresight and careful planning. A typical instance is that 
of a knitting mill in an eastern state which is capitalized at 
$900,000, $600,000 common and $300,000 7% cumulative 
preferred stock. The quick assets are $450,000 in excess of 
its quick liabilities, and the company has a surplus of 
$500,000. This corporation, like most all other textile con- 
cerns, borrows heavily from the banks. It seldom has loans 
of less than $600,000 outstanding, and frequently they rise 
to $900,000; the loans are obtained at an average rate of 



SOURCES OF CAPITAL FUNDS 221 

5^2%. The question that has been raised and is now under 
consideration, is whether it would be desirable to put out 
an additional $300,000 of 7% preferred stock at par, thus 
cutting down the bank borrowing. 

To this question there is apparently one sound answer. 
When bank loans of this concern reach their maximum of 
$900,000, these loans are equivalent to the whole capital stock, 
and the margin of quick assets is too small for safety. A 
failure to dispose of the products of the mill on the usual 
terms and at the usual time might suddenly bring on bank- 
ruptcy. The case of the National Cordage Company already 
cited is in point. Because of its extensive and growing busi- 
ness, the corporation is evidently driving toward a possible 
financial position of serious danger. It is expected that the 
directors will shortly take action authorizing the sale of pre- 
ferred stock and reducing the bank indebtedness by a cor- 
responding amount. The result would be to reduce the earn- 
ings on the common stock by approximately $4,500 per year, 
but this is a small item compared to the gain in safety. 

It may be asked why the problem is not solved by placing 
a mortgage upon the mill and thus borrowing on better terms 
than through the issue of preferred shares. The answer is 
that, in the textile industry it is a well-recognized principle 
that mill property should not be mortgaged. Cotton mills 
borrow from the banks so heavily that a banker would look 
with much disfavor on any permanent loan that would out- 
rank his claim. 

Incorporating a Partnership 

Many puzzling problems arise in connection with the 
custom which has become common in recent years, of giving 
up the partnership form in establishing enterprises and sub- 
stituting the corporate form of organization. During the 
life of the partnership numerous personal agreements have 



222 SECURING CAPITAL 

probably been entered into which it is difficult either to 
continue or replace under the corporate form. Moreover, one 
essential feature of the partnership form is that every partner, 
irrespective of his financial interest, shall have an equal voice 
in the management of the enterprise. If there is wide 
discrepancy between the financial interests of the partners, it 
is difficult to continue this arrangement under the corporate 
form. The following is a concrete example which will make 
clear these difficulties: 

Three partners, A, B, and C, conduct a jobbing business 
established 60 years ago by A's father. A, having inherited 
his father's estate, is the principal owner and the head of the 
concern ; B, who began 30 years ago as a clerk, is in charge of 
the production and a large share of the selling ; C, who entered 
as a bookkeeper 20 years ago, is in charge of the financing, 
office management, and credits. The capital of the firm is 
$325,000, of which A owns $275,000, B $35,000, and C 
$15,000; interest at 6% is paid each partner on the amount 
of his investment; each partner draws a salary of $7,200 per 
annum, and the profits are divided as follows : A 50% ; B 
40%, and C 10%. The annual sales are about $750,000, and 
the net profits $25,000. An important reason for turning 
the partnership into a close corporation is in order to allow 
department heads and some of the salesmen to gain an interest 
in the business. 

It is at once evident, in considering this case, that its 
difficulty arises out of the fact that profits are divided without 
any fixed relation either to investment of capital or to the 
value of services. Six per cent is hardly a sufficient rate of 
return on the capital employed in a business of this character, 
so that it is no doubt intended to give some special allowance 
to A in the division of profits, that will constitute an increased 
return on his capital. However, this cannot be the controlling 
interest since B, with a comparatively small investment, re- 



SOURCES OF CAPITAL FUNDS 



223 



ceives 40% of the profits. The problem is to preserve these 
various rights and claims under the corporate form. 

It would be possible to issue 6 c /c bonds of the proposed 
corporation to A, B, and C to represent their respective invest- 
ments, but, inasmuch as this is a jobbing business, it would be 
preferable to issue preferred stock rather than bonds. We will 
start, then, by providing for the issuance of $325,000 of 6% 
cumulative preferred stock; $275,000 to A, $35,000 to B, and 
$15,000 to C. The best method of determining the total 
amount of common stock to issue is to capitalize the remaining 
$25,000 of profit at some reasonable percentage, say 8%, 
making the common issue $312,500. If we assume that the 
distribution of profits to the three partners is meant to repre- 
sent their permanent contributions to the upbuilding of the 
business, this $312,500 of common stock should be divided 
among them, 50% to A, 40% to B, and 10% to C. Possibly 
this division of profits in the partnership is meant rather to 
represent discrepancies in the abilities of the three men in 
directing the affairs of the business ; if that is the case, these 
discrepancies should be adjusted by corresponding changes in 
the salaries* of the three men, which in turn would involve a 
different distribution of the common stock. 

Now comes the difficulty of giving each one of the partners 
an equal voice in the management of the corporation such as 
he now has in the management of the partnership. The sim- 
plest method of accomplishing that result, and generally the 
most satisfactory, is to create a voting trust, which should not 
be for more than five years. There would be a possibility, also, 
of making a part of the common stock non- voting, so as to 
make certain that each of the partners will be able to elect a 
member of the board of directors, but this is a somewhat cum- 
bersome device. If it is adopted, it would be well to provide 
in the by-laws for cumulative voting so as to make impossible 
a combination of two partners to freeze out the third. 



224 



SECURING CAPITAL 



Financial Plan for a Railroad 

Another problem, which is of especial interest in illus- 
trating some of the principles discussed, arose in connection 
with the proposition to finance the construction of a short rail- 
road and the establishment of a steamship service in one of 
the southern states. The whole project involved an invest- 
ment, including terminals, of about $4,183,000. The probable 
gross earnings after two years from date of opening the road 
to operation, were calculated at $2,018,000; operating ex- 
penses were estimated at 65%, say $1,300,000, and taxes and 
insurance at $80,000, making the total expense, $1,380,000, 
and leaving a net revenue of $626,125 from which to meet 
fixed charges and provide a surplus. It is estimated also, that 
there would be a deficit close to $100,000 during the first 
two years of operation. Equipment was expected to cost 
$1,650,000. The total capital required was as follows: 

Cost of construction $4,183,000 

Cost of equipment 1,650,000 

Loss in first two years of operation 100,000 

Working capital 500,000 

Total $6,433,000 

A certain amount of capital required for the earlier stages 
of construction is necessarily tied up without any income to 
pay the interest on it, until the road is put in operation. To 
take care of this expense it would be well to form a construc- 
tion company to build the road and furnish all other necessary 
property and cash. The construction company should be pre- 
pared to hand over to the railroad company $600,000, that 
sum being required to cover the loss of the first two years of 
operation and to provide working capital. The construction 
company should also pay interest, taxes, insurance, etc., up 
to the time the property is handed over to the railroad com- 
pany. In exchange for the railroad and the cash, the railroad 



SOURCES OF CAPITAL FUNDS 225 

company would then turn over all its securities to the construc- 
tion company, which securities the construction company would 
sell and out of which it would derive its profit. The pro- 
moters of the railroad would naturally be the owners of the 
construction company. 

On the basis of normal earnings of $626,125, the corpora- 
tion might be capitalized as follows : 

Cash Fixed and 

Nominal Receipts to Contingent 
Value Corporation Charges 
S l A% first mortgage bonds on all 
property, exclusive of equip- 
ment, to be disposed of at 90 
with a bonus of two shares of 
common stock to each $1,000 

bond $4,000,000 $3,600,000 $220,000 

6% one to ten-year serial equip- 
ment notes 1,500,000 1,500,000 90,000 

Annual payment during first ten 
years of operation to retire 

above notes 150,000 

7% cumulative stock to be dis- 
posed of at 90, with a bonus 
of common to each five shares 
of preferred 1,500,000 1,350,000 105,000 

$7,000,000 $6,450,000 $565,000 

This leaves a balance of $61,125 a year available for con- 
tingencies out of the income of the first ten years. 

The common stock required for bonuses to purchasers of 
the first mortgage bonds and of the preferred stock, is 
$1,300,000. The promoters of the enterprise will want some 
pay for their services, and will probably want to retain con- 
trol of the company. They should, therefore, issue approxi- 
mately $4,000,000 of common stock to the construction 
company. Under the above estimates $2,700,000 will be left 
for themselves. 

For the first ten years — unless the earnings should largely 



226 SECURING CAPITAL 

increase — the common stock could not expect to receive any 
dividends. It will be noticed that $150,000 worth of serial 
notes is to be retired each year, and that the interest on that 
amount each year should be added to the balance available 
for contingencies. At the end of ten years, not only will 
there be no interest to pay on the notes but the annual pay- 
ments on the principal will cease. Thereafter $301,125 may 
be disbursed as dividends on the common stock. This means 
about 7/^% earnings on the common stock. 

It will be noted that in the above arrangement, first mort- 
gage bonds are issued to an amount approximately equal to 
the actual cost of the property mortgaged. This may seem to 
be, and is in fact, somewhat reckless financing; yet it must be 
assumed that the project itself is worth something and that 
the rails, buildings, and real estate, which are the chief items 
in cost, are worth more after they are laid down and the rail- 
road is ready for operation, than their actual cost. The pre- 
ferred stock is more than equivalent to the remaining balance 
of all the tangible assets and is partly offset by good-will. The 
proposed common stock issue of $4,000,000 is offset wholly by 
good- will. The amount of each class of security that may 
safely be issued has been determined rather with reference to 
the earnings than with reference to the assets. It is assumed 
that there is little likelihood of failure to meet the fixed charges 
amounting to $460,000. 

Financing an Advertising Agency 

At the other end of the scale from a railroad company is 
an enterprise, such as an advertising agency, which renders a 
service that is largely of a personal nature analogous to the 
service rendered by a lawyer, physician, or consulting engineer. 
It is true, of course, that many of the functions of an adver- 
tising agency are of a more or less clerical nature; but the 
more important functions are advisory and cannot be per- 



SOURCES OF CAPITAL FINDS 227 

formed properly except by well-qualified, high-priced men. 
For this reason the growth of an advertising agency, if it is a 
healthy, permanent growth, is necessarily a rather slow process. 
The time and energy of the principals are limited, and, if an 
attempt is made to spread their efforts over too many under- 
takings, the result is apt to be unsatisfactory both to their 
clients and to themselves. 

It would seem, therefore, in considering the financial prob- 
lems of an established agency, that a reasonably rapid growth 
ought to be financed directly out of the profits of the agency. 
It is not necessary to maintain a great working capital in pro- 
portion to the volume of business handled, for an advertising 
agency usually pays its bills on the same terms that its own 
bills to clients are paid by them. For example, if an advertis- 
ing agency gets a discount of 2% for cash in 10 days, it should 
give the same discount to its clients and thus secure the cash 
from them with which to meet the bill. 

In one instance, however, an advertising agency was as- 
sisting some of its clients to carry on large advertising cam- 
paigns by granting them extra time for the payment of their 
accounts while the advertising agency was paying its own bills 
on the minute. The result was that it suddenly became neces- 
sary to add $75,000 to $100,000 to the working capital of the 
agency. The agency had been in existence for many years, 
was highly regarded, and was making satisfactory profits, so 
that its record favored the suggestion that preferred stock be 
sold to some of the personal friends and acquaintances of the 
president of the agency. In order to make the stock attractive, 
however, it was found desirable to give it a participating fea- 
ture, which would make the possible net earnings run as high 
as 25%. Under these conditions the stock was sold. It is, 
however, rather an unusual instance of raising cash by sales of 
securities, for an enterprise in which personality plays so 
prominent a part. 



228 SECURING CAPITAL 

Simplicity Desirable 

The successful financial plan is not usually one that is 
highly involved and full of unusual and supposedly ingenious 
little expedients. It is more likely to be simple and to look 
beyond the needs of the moment. The chief financial virtue 
is foresight. Hit-or-miss financing is almost certain to involve 
either waste or danger. 

We will see this exemplified over and over again in dis- 
cussing the tangled affairs of insolvent corporations which are 
in process of reorganization. One of the noteworthy advan- 
tages of most reorganizations is the greater simplicity which 
is secured through refunding small and isolated issues into a 
few large issues with well-defined claims. 

It is usually best, also, to work along conventional lines. 
Originality is only too apt to arouse distrust. There is almost 
an established routine in organizing public utility corporations, 
which is about as follows: First mortgage 5%, bonds are 
issued up to 75 to 80% of the cost of construction or, if the 
company is a consolidation, of the value of the combined fixed 
assets. These bonds sell to bankers at 95 to 100. 7% pre- 
ferred shares are then issued for the balance of the tangible 
assets plus a reasonable amount of good-will. It is expected 
that the preferred shares will be able to keep up their divi- 
dends. They are usually taken by bankers at about 95. 
Common stock is then issued to such an amount that the re- 
maining earnings, after the period of development is over, 
will be sufficient to pay at least 4 or 5%. This would be con- 
sidered a conservative method of capitalization, and in fact it 
would be difficult to suggest any striking improvement 



CHAPTER X 
PROMOTION 

Three Steps in Promotion 

After a financial plan has been formed and agreed upon 
by all parties interested, the next step is to put it into opera- 
tion. If the only persons who are to be identified with the 
new enterprise are those who have talked it over among them- 
selves and come to a decision as to the plan, there can hardly 
be said to be a separate process of persuading them to accept 
the plan and to purchase the securities of the new enterprise. 
But, when an enterprise is large enough to necessitate the 
seeking of capital outside the original circle, then there is a 
distinct stage of shaping the proposition into salable form and 
of raising the required capital through the sale of securities, 
which process is known as "promotion." 

As to the legitimacy and usefulness of the promotion of 
sound and beneficial enterprises there can be no real question. 
The promoter finds an opportunity and turns it into a reality. 
His work has been in part discredited because the term "pro- 
motion" has been misapplied to man) swindling efforts to sell 
worthless stock. In its proper meaning, however, it should be 
a term of honor. The promoter is the organizer who brings 
together capital and an enterprise in which capital can be use- 
fully and profitably employed. 

If promotion is carried on properly, it is divisible into 
three distinct stages. First comes the thorough investigation 
of the new enterprise in all its phases. Sometimes the pro- 
moter is so familiar with the enterprise that this stage may 
be almost overlooked; more frequently, he possesses merely a 

229 



230 



SECURING CAPITAL 



general knowledge of similar enterprises, which knowledge 
enables him readily to grasp the particular enterprise before 
him. It is dangerous, however, for him to make any assump- 
tions without full and accurate verification. The next step in 
promotion is the so-called "assembling" of the enterprise, that 
is to say, forming the -financial plan, securing options, charter- 
ing the new corporation, and otherwise making the final prepa- 
rations for selling securities. The third step is the financing 
of the new enterprise, that is, the actual selling of the securi- 
ties for sufficient capital to establish the business. 

Stages of Investigation 

The investigation of a proposed new enterprise may be 
divided into three stages : 

i. A preliminary analysis and review of the field in which 
many approximate tests of the probable revenue and expendi- 
tures may be applied. Sometimes an hour or two of careful 
figuring and thinking, based upon a general knowledge of 
the proposition, will determine whether it is worth while to 
proceed with further study. 

2. The next stage is a preliminary study of the important 
facts, corresponding to the preliminary survey of a new rail- 
road line, which maps out its course but does not attempt to 
cover all the details. It should be possible at the conclusion 
of this stage to form a final judgment as to the prospects of 
the enterprise. 

3. Finally there should come a detailed investigation of 
the location of the enterprise, the sales markets, the personnel 
or proposed personnel, and of numerous other factors, with a 
view to making certain that no hidden weakness exists. 

This is the process that would be gone through in making 
a thorough investigation of an entirely new proposition, as 
for instance, an interurban railway. First, anyone considering 
the promotion of the railway would get general data as to the 



PROMOTION 231 

population of the territory, length of the line, expense of build- 
ings, operation, etc., and would determine whether it was 
desirable to go ahead. Second, he would have a definite sur- 
vey and study of the traffic possibilities made for him. Third, 
he would go into detail as to the layout of the line, the cost of 
right of way, the nature and cost of the franchise, and so on. 

Thoroughness in Investigation 

Most promoters, however, have to do, not with entirely 
new enterprises, but with readjustments or combinations of 
old enterprises; consequently, some of the processes of 
investigation may be eliminated. The common tendency is 
to slur over all of it, and the common result is that calcula- 
tions of prospective earnings, of the amount of capital 
required and the like, are frequently far removed from the 
truth. This is just the point at which slipshod methods do 
most harm. 

Frequently the most casual incidents, supplemented per- 
haps by a little additional thought and some feeble investi- 
gation, furnish the sole basis of knowledge for an enormous 
investment of capital. The formation of the American 
Malting Company, in 1897, was the outgrowth of an acci- 
dental suggestion to one of the large makers "during a con- 
versation held while crossing Boston Common." 

At the time of the formation of the United States Ship- 
building Company, in 1902, President LeRoy Dresser, of the 
Trust Company of the Republic, was, one day, lunching with 
Lewis Nixon when Charles M. Schwab happened to stop at 
the table and remarked: "Why don't you buy the Bethlehem 
plant ?" Less than three weeks later Mr. Schwab had agreed 
to turn over the stock of the Bethlehem plant to the Ship- 
building Company for $10,000,000 collateral trust bonds, 
$10,000,000 preferred and $10,000,000 common stock. 

The formation of the American Bicycle Company in 1898 



232 SECURING CAPITAL 

resulted from a chance remark made by Colonel J. J. McCook, 
a prominent lawyer, to A. G. Spalding, a manufacturer of 
bicycles. 

"Have you observed the movement toward combina- 
tions apparent everywhere?" asked Colonel McCook. 

"Yes," replied Mr. Spalding. 

"Have you ever thought of the possible application 
of the combination idea to the bicycle industry?" 

"Not seriously." 

"I wish you would think it over; it seems to be work- 
ing in many cases."* 

Preliminary Analysis 

The preliminary analysis and review of the underlying 
conditions has been best standardized, perhaps, in public utility 
fields. A great number of projects of this nature have been 
presented during the last two decades, and bankers have 
worked out and come to accept certain well-defined standards. 
They know, for instance, the approximate amount of gross 
earnings which can be expected from a given population. 
Their preliminary estimates of earnings are based upon 
approximately the following probable yearly receipts, from 
each person in the territory covered by the public utility :f 

Electric light and power com- 
panies, $3.00 to $6.00 per capita 

Gas companies, 2.00 " 6.00 " 

Electric street railways in small 

cities, 4.00 " 5.00 " " 

Electric street railways in large 

cities, 7.00 " 10.00 " " 

Interurban railways, 6.00 " 10.00 " " 

The New York Annalist describes the preliminary survey 
of electrical railway projects as follows: 

*Dewing's "Corporate Promotions and Reorganizations," pp. 251, 272, 484. 
fFrom "Promotion and Organization of Public Service Corporations," by L. R. 
Nash, of the Stone and Webster Engineering Corporation: 



PROMOTION 233 

There are 25 or 30 banking houses in New York City 
that specialize in financing electrical railways. Each of 
them is supposed to receive 500 to 1,000 proposals for 
building new lines or purchasing and rehabilitating old 
lines each year. 

In judging these new projects, the bankers take into 
consideration, first of all, the political attitude of the state 
or city in regard to public utilities. They have on file 
tabulated data with regard to the political record and 
activities of each state. They consider, next, the United 
States census figures of population and statistics, which 
indicate the rate of growth of population. 

Next, the promoter is asked to pay the expenses and fees 
of an expert engineer designated by the banking house, 
who makes a preliminary survey of the proposed line. 
He tabulates the number of cuts and fills and arrives at 
an approximate estimate of the cost of construction. He 
also inquires closely into the cost of rights of way and of 
terminals. His advance estimates of cost of construction 
and operation are generally expected to come within 5% 
of the actual figures. 

This preliminary report is then checked against the 
previous experience of the house. They add to the cost 
of construction the carrying charges on the investment 
before it begins to make any return. They may get bids 
on the construction of power plants. This office analysis 
and checking is expected to result in very accurate esti- 
mates of gross earnings and of oui.go. 

Some bankers decline to take up any such propositions 
unless advance estimates show net interest earnings equal 
to two and one-half times the interest charges on the 
bonds that will be necessary. Each mile of track should 
earn a minimum of $5,000, which is a generally accepted 
figure for interurban roads. 

If the operating cost is 60%, this leaves net earnings 
of $2,000. If the construction cost is $25,000, all provided 
by bonds at 5%, the interest charges per mile are $1,250, 
leaving $750 per mile to provide for depreciation, unex- 
pected losses, and accidents. 

A population per mile in a strip two miles wide on 



234 SECURING CAPITAL 

each side of the road of one thousand is considered a 
safe minimum. The interurban railroad which exists 
mostly on paper is not in large favor, as it is believed that 
most of the choice locations have been occupied.* 

Investing Upon an Uncertainty 

By way of contrast with the care and the foresight 
exercised in estimating the possibilities of public utility 
propositions, as shown in the above quotation, take the 
experience of the Canadian Sardine Company which some 
years ago put up a half-million dollar plant at St. John, New 
Brunswick. The plant was thoroughly modern and efficient 
and was expected to yield large profits. Unfortunately, there 
was a period of two or three years after the completion of 
the plant when the sardines did not run. It was impossible 
to carry on the business and the company went into bank- 
ruptcy. Shortly thereafter, the sardines returned to the New- 
foundland fishing banks, but it was then too late. This is 
a striking, but by no means extreme, instance of establishing 
a business and investing a large sum of money upon an 
uncertainty. It is precisely what careful, preliminary investi- 
gation will avoid or at least minimize. 

Scope of Investigation 

We cannot here enter into a discussion of the technical 
points and subjects which are covered in the investigations 
of many different projects, for their range is infinite. A 
well-known engineering firm has had under consideration 
within the last two years such various projects as: irrigation 
work in Brazil; a steam railroad in the Philippines; a street 
railway in South Africa; and hundreds of proposals within 
the United States. Every one of these proposals that seems 
worth while is reported upon at great length by a trained 
engineer and investigator. The stock of information which 



f New York Annalist, July 20, 1914. 



PROMOTION 



235 



is included in the reports filed with the head office of this 
firm is enormous. It includes many studies of sociological 
and political conditions, as well as of more technical con- 
siderations of construction and engineering. Each one of the 
more elaborate reports is well illustrated with photographs 
pasted into the typewritten pages. Often a report will run 
from 50,000 to 200,000 words and yet will contain only 
essential information boiled down to as brief a space as 
possible. 

Some general statements as to questions to be considered 
in an investigation are included in a paper on "Initial 
Financing of an Enterprise" by E. K. Chapman, president of 
the Hudson Trust Company of New York City, which was 
read at a meeting of the Efficiency Society in March 19 14. 
According to Mr. Chapman, in promoting a corporation which 
is taking over either tangible property or patent rights, copy- 
rights, good-will, and the like, there are eight points which 
should receive careful consideration at the outset. 

1. The validity of the patents, copyrights, and other 

titles and rights, or the soundness of the claim of 
good-will. 

2. Strength and dangers of present and potential com- 

petition. 

3. Likelihood of securing for the new company the 

proper grade of managerial talent. 

4. Sufficiency of capital and dependable resources; this 

should be enough, not merely to get along if every- 
thing goes well, but to include the expenses and 
losses of the early experimental stage. It is 
generally not desirable to apply a second time to 
the people who subscribed the original amount of 
capital stock. 

5. The par value of the capital shares, which should be 



236 SECURING CAPITAL 

low if the appeal is to be made to small investors, 
and not less than $100 if the appeal is to be made 
to large investors. 

6. The contract between the corporation and the pro- 

moter; the promoter should be reimbursed in cash 
for his actual cash expenditures, but the compensa- 
tion for his services should be in the form of shares 
in the corporation. 

7. Necessity of investing a large sum of capital in con- 

structing a plant for manufacturing the proposed 
product ; ordinarily it is less risky to start by having 
the product manufactured under contract by out- 
siders or by assembling the parts which have been 
manufactured under contract. 

8. Probability of securing capital from men with experi- 

ence in similar lines of business or with special 
information. 

It is well for a banker, or investor, or anyone else who 
has to do with financing new enterprises, to have some such 
list as Mr. Chapman's before him in order to make sure he 
is not overlooking any essential point. It may be of some 
value to comment briefly on a few cases in which the writer 
was called upon to make a preliminary analysis and to indicate 
what information ought to be had. 

A Simple Example 

A proposal which was brought up for criticism some time 
ago, was to form a new company which should build a 
modern ice cream plant, with the latest labor-saving devices 
and the best methods for the manufacture of pure ice cream, 
with a capacity of 3,000 gallons per day, in the vicinity of an 
important southern city. Among the more important ques- 
tions on which exact information should be secured, it was 
suggested, were the following: 



PROMOTION 



237 



What is to be the cash investment in real estate? In 

machinery ? In horses, wagons, and other equipment ? 
Will it be necessary to extend credit to any considerable 

extent to your customers? Is there likely to be any 

trouble with collections? 
How much do you expect to borrow on mortgage? 

How much do you expect to borrow from banks? 

How large will your accounts payable normally be 

and what will be the average terms of payment? 
What working capital in addition to your permanent 

investment in buildings and equipment are you pro- 
viding for? 
What is to be the capitalization of the company? What 

kinds of stock and notes or bonds are to be issued? 
Are you sure of getting excellent management? 
Has provision been made for repairs to machinery, fuel, 

light, office equipment and supplies, drivers and 

helpers, etc.? 
Will the estimated volume of sales in practice be 

obtained without prohibitive expense? At what 

expense ? 
What is the earning power of the corporation likely to 

be after deducting all selling and administrative 

expenses ? 

A Complex Instance 

A proposal of more complexity came from a southern 
state in which it was planned to build a railroad of less than 
30 miles through three prosperous villages and opening up a 
rich agricultural and lumber country to Port "D" and the sea. 
Some information was furnished by the intending promoter 
of this project, but the data as at first submitted was so incom- 
plete that it was necessary to draw up a list of definite ques- 
tions, which are given below, with a view to securing such 



238 SECURING CAPITAL 

information as would be at once required by a banker or 
bond dealer if he were to look into the proposition at all. 

i. How much traffic is now hauled by existing trans- 
portation agencies in this region? 

2. How much standing lumber will be made available 

for shipment by this new road? 

3. What are the important markets for this lumber? 

4. At what price can it probably be sold in these 

markets? 

5. What, approximately, will be the cost of cutting and 

of hauling lumber to railroad and loading on cars ? 
(Answers to the above questions will give a basis 
for figuring the possible rates on lumber from 
the point of loading to the markets.) 

6. Just how much rail and water traffic through "D" 

is in sight? 

7. What advantages as a port for rail and water traffic 

will Port "D" have over competing ports? 

8. What inducements can be offered which will lead to 

the diversion of traffic now moving through com- 
peting ports to the route through Port "D"? 

9. At what rates does traffic now move through com- 

peting ports to and from the markets which the 
promoter hopes to reach by his proposed route? 
10. What is the attitude of connecting rail and water 
lines? Will they be inclined to assist in the 
development of Port "D" or will they find it to 
their interest rather to discourage the growth of 
this port? (This is, perhaps, the most important 
question of all, for a short railroad, such as the 
promoter has in view, could scarcely exist, let 
alone thrive, unless it has the cordial co-operation 
of connecting lines.) 



PROMOTION 



239 



11. Assuming that connecting lines are friendly, what 

rate per ton-mile can the proposed railroad prob- 
ably secure on the through traffic? 

12. What will be the exact cost of securing the right of 

way and constructing the proposed road ? 

13. What will be the cost of providing docks and other 

terminal facilities at Port "D"? 

14. Do the above estimates contemplate providing a 

well-built, modern road, or rather a temporary 
construction which will have to be replaced later? 

15. What will be the cost of equipment and of necessary 

supplies of all kinds? 

16. Will it be possible to secure local subsidies or other 

assistance ? 

17. Does the promoter have banking connections on 

which he can rely for assistance in floating the 
securities of the proposed road? 

18. Does the promoter know any capitalists who will 

probably be willing — provided satisfactory an- 
swers to all the above questions are given — to buy 
the stock issues of the proposed road? 

19. Is the promoter able and willing to incur the large 

expense that will be necessary to secure correct, 
dependable answers to all che above questions? 

The process of securing answers to the questions above 
listed would in each case probably bring to light many addi- 
tional questions requiring investigation. Just what these 
questions may be could not very well be determined in ad- 
vance, inasmuch as they would result in part from the local 
conditions under which the project is to be established. By 
working out a list of questions in their logical sequence and by 
getting the most complete and trustworthy answers possible, 
the promoter may be certain that he is leaving nothing of great 



240 SECURING CAPITAL 

importance uncovered. To be sure, there may be unfortunate 
slips and omissions even in the most thorough investigations, 
but they will generally be found to be due to peculiarities of 
the business or of the locality in which it is carried on which 
escape the eyes of a stranger. For this reason it is always 
very desirable that the investigator should associate himself 
as closely as possible with a man who is thoroughly familiar, 
by long experience, with the peculiarities of the project. 

"Assembling" a Proposition 

As an illustration of the casual way in which people some- 
times take a hand in promoting new enterprises, a case was 
reported recently of a manufacturer, whom we will designate 
as A, who was desirous of joining forces with a certain large 
corporation or of selling out to it. He came into contact with 
a broker and promoter, B, who was acquainted with a second 
promoter, C, who had facilities, in B's opinion, for putting 
through just the deal that A had in mind. B took A over to 
C's office, introduced him and explained that in view of Cs 
facilities he would step out of the transaction, expecting, how- 
ever, to be taken care of in case the deal were consummated. 
Later the transaction was actually effected and the question 
immediately arose as to what compensation B ought to obtain. 

There is no such thing as a standard rate or a standard 
method of fixing the compensation for financial promoters, 
and in this case there was no definite bargain in advance. B 
could certainly have no legal claim, inasmuch as he had per- 
formed no service, and it is questionable if he would have any 
moral claim except for a small honorarium. A mere sugges- 
tion or an introduction can hardly be claimed to have a high 
commercial value. Yet B from his point of view might well 
reason that, without him, A would probably not have made 
the deal which was so profitable to him, and that B conse- 
quently was fairly entitled to a large proportion of these prof- 



PROMOTION 



241 



its. The question can never be answered one way or the other 
to the satisfaction of both parties. It is clear that it should 
never have been allowed to arise. B was careless and unbusi- 
nesslike in his dealings. If he thought there was any reason- 
able chance of putting through the transaction, he should have 
arranged with C for a definite proportion of his commission. 
Evidently, under the definition that has previously been given, 
B did not have in this case a properly "assembled" proposition. 

Another case in which, according to the promoter's own 
story he failed to give himself proper protection, came into the 
New Jersey courts a few years ago, and was decided by the 
Court of Errors and Appeals in 1 912. It appears that Harry 
C. Haskins claims to have been the originator of the scheme to 
unite all the independent lead companies not previously in- 
cluded in the National Lead Company. He went to Thomas 
F. Ryan, the well-known financier, and enlisted his support. 
Mr. Haskins charges that after Mr. Ryan and his friends had 
secured from him all the information they needed, and had 
made use of his knowledge of the lead business, resulting from 
years of study, they froze him out of the deal. His claim was 
that, while Mr. Ryan had made enormous profits as promoter 
of the consolidation, he himself had received nothing. 

Without attempting to express any opinion whatever on 
the merits of this case, it is plain that in the eyes of the law 
Mr. Haskins could have little standing. He had no property 
right in the idea of forming the consolidation; the facts and 
figures which he submitted to Mr. Ryan were apparently 
freely given. He may have had a verbal understanding, but, 
if so, it can best be described as an agreement to make an agree- 
ment, fulfilment of which cannot, of course, be compelled in 
equity proceedings. In other words, the original promoter, 
Mr. Haskins, according to his own statement, did not con- 
tractually protect himself. He went ahead before he had 
"assembled" his proposition. 



242 SECURING CAPITAL 

Protection of Promoter 

Much the same thing has happened over and over again 
in organizing combinations. A promoter may get the idea of 
bringing certain companies together and may start talking first 
with one manufacturer and then with another; in a short time 
he finds that the idea is being generally discussed and that the 
manufacturers are talking direct with each other. A little later, 
if the whole plan looks sound and attractive to them, they are 
very likely to come together almost of their own accord or 
through the efforts of some of their lawyers or of some other 
person besides the original promoter. Unless the promoter is 
himself a man of such personal acquaintanceship and force 
that his assistance is a positive and essential factor in forming 
the combination, it is almost certain that his claims to com- 
pensation will get very slight consideration. No one among 
the manufacturers can undertake to look after the promoter's 
personal interest; he is supposed to do that for himself. The 
only method he can successfully follow is to secure contracts 
or options which will put him in a position of distinct legal 
advantage. When he has secured these contracts or options, 
then, and not till then, his proposition is assembled. 

Purchase Outright 

If the promoters and the financiers working with them are 
well supplied with cash, their problem may be much simpli- 
fied. In the promotion of the Mount Vernon- Woodberry Cot- 
ton Duck Company in Baltimore, 1899, the promoters acquired 
fourteen mills by making a separate bargain with each manu- 
facturer and paying to him an agreed price in cash. The price 
fixed with one manufacturer was not known to the others. 
In working under this method the promoters were, of course, 
assuming a large personal risk which it is frequently impossible 
for the organizer of a large combination to take upon himself. 

The next most secure plan is to persuade each concern 



PROMOTION 



243 



that is to be taken into the combination, to grant an option for 
a limited period at a fixed price. After the promoter has 
secured enough of these options to assure the realization of the 
project, he is then in position to form a definite proposition 
and take it up with bankers for the purpose of securing finan- 
cial backing. The methods of securing options may differ 
in each case, and a separate bargain will in each case be driven. 
When the United States Shipbuilding Company was first pro- 
moted, in 1899, Colonel John J. McCook and John W. Young, 
the promoters, first of all persuaded Lewis Nixon to give an 
option on his Crescent Ship Yard and adjoining property, 
with the understanding that Mr. Nixon should consent to act 
as general manager of the proposed consolidation. In getting 
together such a proposition as a new street railway, it is often 
necessary to secure option on rights of way and to obtain fran- 
chises from the city and county authorities in order to forestall 
"hold-ups" at a later period in the development of the proposi- 
tion. Under such conditions, these options must be obtained 
very quietly and quickly. 

Sometimes the process of "assembling" is completed when 
the promoter has obtained a control over some one plant or 
some one portion of the contemplated project which is regarded 
as essential. This control puts him in a position of strategic 
advantage. There can be no general rule as to assembling; 
the most that can be said is that the promoter must put himself 
and keep himself in a position of mastery over the situation. 
If he does not do so, he cannot expect, and, as a matter of fact, 
he has no right to expect, any large compensation for his ser- 
vices. He is playing his game on the implied understanding 
that in case he obtains a position of advantage he will expect 
a large return for his services, which must, in fairness, be bal- 
anced by the understanding that in case he finds himself at a 
disadvantage he will get very little return. 

The promoter's relation to the people with whom he is 



244 SECURING CAPITAL 

dealing is not that of one banker or business associate to 
another, but is rather that of buyer and seller of a product 
which has no fixed value. The promoter is endeavoring to 
get the highest price obtainable, and the owner of the property 
or of the cash that goes into the enterprise quite properly 
wishes to do the best he can for himself. 

Preliminary Financing 

As soon as the promoter starts to develop a new proposi- 
tion, he begins to establish — if he has not previously done so — 
the banking connections that will be of greatest use in con- 
nection with the enterprise. These connections should be with 
banks that are already familiar, through their own experience, 
either with the line of business or with the field of operations 
of the business in which the promoter is working. To be 
specific, if the project is to establish an interurban railroad 
near Dallas, Texas, the promoter will look for his financial 
connections either among the New York, Boston, Chicago, and 
St. Louis banking houses that are accustomed to investigating 
and floating interurban properties, or among the Dallas bankers 
who thoroughly know the local situation and can perhaps 
assist in raising funds from local people. The active co- 
operation of interested bankers is quite essential to the success 
of most promotions. The first stage of the financing in which 
the banker plays his part may be reached when the purchase 
of options or the outright purchase of property is under con- 
sideration. The bankers interested may, at this point, create 
a syndicate which will advance money to the promoter for the 
purchase of options on the property, with the agreement that 
repayment is to be made as soon as the promotion is success- 
fully floated. If the expenditure at this stage is for options 
only and the promoter's personal means should not allow him 
to go ahead unassisted, he very likely would attempt to organ- 
ize a small syndicate among his personal acquaintances who 



PROMOTION 245 

would be willing to share with him equally the risks and the 
profits of the promotion. Ordinarily, the bankers would not 
step in unless outright purchase on a large scale was called for. 

The next stage at which bankers' co-operation may be 
called for is during the period of development, when the 
promotion involves a great deal of construction; or the period 
of waiting, when the promotion is a combination that can- 
not at once be financed by the sale of securities to the public. 
Let us take an assumed example for the sake of clearness. 
A new manufacturing company is to put up a plant costing 
$1,000,000, and provide machinery and equipment amounting 
to $500,000. Let us assume that the product is of such nature 
that there can be no question as to its marketability. It may 
sometimes be desirable and possible to raise the full amount 
of required capital — $1,500,000 in this case — at the outset 
and expend it gradually in the construction of the plant, 
but in other cases this plan will be found impracticable and 
the question will arise as to how to secure the funds with 
which to keep construction going while at the same time 
taking care of the sale of securities. 

The customary plan is to place a mortgage on the 
property acquired or later to be acquired, and to issue bonds 
up to the extent of the mortgage. These bonds, however, 
will not be salable until the property has actually been 
developed. The difficulty may best be met by depositing 
them with bankers as security for short-term loans and using 
these loans to provide funds for construction. The banker 
receives these bonds as collateral, which will eventually be 
salable and, in case the whole proposition is sound, may con- 
sider himself at least fairly well protected. Usually the 
arrangement is that the bonds shall be delivered as construc- 
tion goes on, so that the banker may never have on hand a 
great many bonds representing property that exists as yet 
only on paper. 



046 SECURING CAPITAL 

The analogous difficulty in case a combination is formed, 
the securities of which are not at once salable, is met in the 
same way. The securities are posted as collateral for bank 
loans and the loans are later paid off as the securities are 
disposed of. 

By means of this preliminary financing, an enterprise 
can be financed even though the promoter and his immediate 
friends may have limited funds up to the point when the 
sale of securities to the public brings in the required amount 
of capital. 

Foresight in Providing Funds 

One of the most common errors — and also one of the 
most dangerous — in organizing a new corporation is to start 
it off with insufficient capital to carry it through to success. 
The result is that the new corporation perhaps makes a fine 
start, gives promise of yielding large profits, and then sud- 
denly threatens to collapse because the supply of cash has 
been exhausted. Credit is not readily available for most new 
corporations. The organizers turn hopefully to the natural 
recourse of selling more stock, and usually find themselves 
confronted by a blind wall of skepticism. It is a curious 
fact that an entirely new project, which exists only as an 
idea and has not yet been troubled by any of the harsh 
vicissitudes of business existence, appeals strongly to the 
imagination and is generally able to command capital with 
comparative ease; whereas exactly the same project six 
months or a year later, when substantial progress has been 
made and its profitableness has been in part demonstrated, is 
no longer appealing and raises new capital with difficulty. 
The reason is no doubt to be found in the fact that the 
owner of capital in the second case looks at the project at 
close range, sees it in its prosaic realization and can hardly 
conceive it as a great money maker. Tn the first place hi? 



PROMOTION 



247 



imagination was left untrammelcd. Promoters are insistent, 
therefore, on one piece of advice in which they all agree: 
in organizing a new enterprise, raise at the outset all the 
capital required to bring it to success. 

Working Capital Required 

One difficulty that often comes up at this point is that of 
estimating the amount of cash capital required. Among ama- 
teur promoters the strong tendency is to underestimate. Even 
where a new proposition is of quite a definite character — that 
is to say, where it involves buying a given property or proper- 
ties at an agreed price, turning out a stable product for an as- 
sured market and selling it at a price known in advance — even 
under such conditions underestimates are frequent. They 
most commonly arise from two oversights: first, the neglect 
to provide sufficient working capital, the need for which will 
be fully discussed later; second, overlooking the incorpora- 
tion and selling expenses necessarily required to start the 
corporation and dispose of its capital stock. Selling expense 
of capital stock may run as high as 25 or 30%, although 
a much smaller percentage, dwindling to nothing, is more 
normal. 

A typical experience in organizing a small corporation 
with insufficient financial backing, has recently been related 
to the author in the following terms: 

About two years ago I was induced to purchase 
stock in the Smith Manufacturing Company,* which 
owned the patents and intended to manufacture and sell 
an office equipment device. Only one other person was 
interested and he took an equal amount of stock and was 
to be the active man at $150 per month. It was nearly 
six months before we were able to get our dies con- 
structed and sufficient stock on hand to go after business, 
and this work took a lot more money than we anticipated. 



*The name is fictitious. 



248 



SECURING CAPITAL 

We also had trouble with our finish and replaced a lot 
of our devices which we had placed in the first few 
months. Manufacturing difficulties were finally overcome 
and we have had no other complaints on that score. Our 
difficulty now is to market the product. Sales for the 
year have been only about 2,500 units. 

Up to this time about $20,000 has gone into the busi- 
ness and as yet we are hardly making expenses on average 
monthly sales of $1,000. It has come to the point now 
where we must find a more profitable method of merchan- 
dising, sell out, or liquidate. We would prefer to sell out, 
but we have nothing very encouraging to offer a pur- 
chaser, so it resolves itself into one of the other two. A 
first-class merchandising man, in whom both of us feel 
confidence, could be secured if we were in position to 
put in another $10,000 so as to make sure that the busi- 
ness runs for another year. Personally, I am convinced 
that with the right plan of sale, the whole project 
would be a tremendous money maker, but we haven't the 
cash ourselves, don't know where to turn for it, and 
haven't much of a record to fall back upon. 



The stories of loss in handling enterprises that are known 
to be in themselves sound and profitable, are so numerous, 
that probably every reader can pick one or more out of his 
own experience or observation. It will take very little analy- 
sis of each one of these cases to demonstrate that the loss has 
been due to carelessness in one or more of the following 
features : 

1. In not ascertaining all the available facts in advance 

of making investment. 

2. In neglecting to clinch the legal rights of the organizer 

by means of contracts, options, or the outright pur- 
chase of some of the essential property. 

3. In failing to establish close relations with financial 

houses which would be of assistance in carrying the 



PROMOTION 



249 



enterprise through the construction stage and up to 
the point where securities could be sold as the issues 
of an established concern. 
4. In making insufficient estimates of capital require- 
ments, having in view not only fixed capital, but 
also working capital and the necessary expenses of 
selling securities. 

All these errors with a little judgment and foresight are 
easily avoidable. 



CHAPTER XI 

THE PROMOTER 

Professional Promoters 

As noted in the preceding chapter, the word "promoter" 
has come to be associated with Colonel Sellers and J. Rufus 
Wallingford, and consequently is commonly regarded as a 
term of reproach rather than of praise. Yet, when it is used 
in its proper sense, it indicates a man of exceptional energy 
and foresight who is able to conceive a new enterprise and to 
set it on its feet. He belongs to the class of men who make 
for progress. 

One unfavorable connotation for the word comes out of 
the expression, "professional promoter." Each one of the two 
words in the expression is innocent in itself, but where they 
are combined they seem to imply an individual who is making 
his money by his wits at the expense of dupes. There is un- 
doubtedly some truth in this implication, for a certain group 
of semicriminals who call themselves brokers and promoters 
make it their business to prey upon struggling enterprises and 
defraud them while they pretend to assist them. 

Yet, there are some men of excellent standing to whom 
the term "professional promoter," if used in its correct sense, 
could properly be applied. Dewing mentions, among other 
men of this type, Charles M. Warner, who took part in promo- 
tions so widely separated as the American Malting Company, 
the Corn Products Refining Company, the Bay State Cotton 
Corporation, the International Cotton Mills Corporation, and 
the National Asphalt Company. He mentions, also, Seymour 
Scott, a small maltster of Lyons, N. Y., whom he describes as 
"a man of great optimism and emotional enthusiasm who later 

250 



THE PROMOTER 251 

promoted another successful combination and still later became 
interested in the promotion of some beet sugar plants, hypothe- 
cated his holdings of American Malting Company stock in 
order to raise money and lost all of it with the failure of the 
beet sugar concern."* 

The phrase quoted in the preceding paragraph, "great 
optimism and emotional enthusiasm/' is a happy characteriza- 
tion of a certain type of professional promoter. He is the 
type who sees visions and sweeps hard-headed business men 
into the current of his own enthusiasm. The other type of 
promoter is the clever schemer — not necessarily dishonest — 
who pits men and interests against each other, or hitches them 
into partnerships, relying not so much on the contagion of his 
own enthusiasm as on his calculations as to the reactions of 
men on each other. 

On the whole, the professional promoter is perhaps less 
flourishing and a rarer phenomenon than was the case ten to 
twenty years ago. There have not been so many large promo- 
tions or so much call for his services. His place, furthermore, 
is being taken by the occasional promoters who come from 
the following classes : 

Local lawyers and bankers 
Engineering firms 
Business executives 

There is little to be said, if we are to speak in general 
terms, of the activities of local lawyers and bankers as pro- 
moters. It is enough to call attention to the fact that ordinarily 
they are natural leaders in organizing new local enterprises. 
If some western country town is establishing a new creamery 
or a new cannery; if in some eastern city there is opportunity 
for a combination of small local manufacturing concerns; if 
a man of inventive talent gets up a new device and begins to 

"Dewing's "Corporate Promotions and Reorganizations," pp. 289, 4-16. 



252 



SECURING CAPITAL 



talk among his friends as to the possibilities of developing it — » 
in any one of these cases the opportunity usually comes straight 
to the lawyer or banker who is in position to give it some of 
his time and thought and perhaps to carry it through to suc- 
cess. The number of such cases of local promotions on a 
small scale is surprising and probably accounts for a consider- 
able proportion of the annual crop of new enterprises. 

Engineering Firms as Promoters 

It is well known that a few large engineering firms of high 
standing have organized and financed and now manage thou- 
sands of street railway and other public utility corporations, 
especially in the smaller cities and towns. Among the most 
important of these firms may be mentioned H. L. Doherty 
Company, Stone and Webster, J. G. White Company, and 
H. M. Byllesby and Company. All of these firms, it is stated, 
have more or less drifted into their present promotion activi- 
ties. The business of each firm was primarily to carry on pro- 
fessional engineering work. As they grew in size and the 
expense of maintaining a large staff of high-priced experts 
became a greater and greater burden, it was found necessary 
to go beyond merely seeking profitable work for these men 
and to embark upon the policy of creating work for them. 
This could be done only by actively organizing and financing 
new corporations with which the firm then made contracts for 
engineering service. Promotion at the beginning, then, was a 
side issue; but it has grown and grown until one, at least, of 
these firms is regarded as much more distinctly a financial 
house than an engineering firm. 

We might include with this group some of the large manu- 
facturing companies which are actively engaged in financing 
new enterprises with a view to obtaining their orders for ma- 
chinery and other equipment. The concern that has followed 
this policy with the greatest enterprise and success is the 



THE PROMOTER 



253 



General Electric Company, which through its Electric Bond 
and Share Company and other subsidiary corporations dis- 
poses of the securities of a great number of enterprises which 
it desires to see developed. 

The essential feature of all these arrangements is that the 
concern which has services or a product to sell does not sit 
back and wait with folded arms until some one else has suc- 
ceeded in interesting capital and in building up the enterprises 
which constitute a market for their services or products. 
Instead, they look for the opportunities where their services or 
products can profitably be used, and then proceed to promote 
the enterprises to handle the opportunities. 

All such concerns, after this policy becomes known, are 
deluged with a constant stream of applications for their assist- 
ance in developing new enterprises in which it is thought they 
might be interested. After receiving these proposals, those 
which appear to be worth while are investigated along the 
lines that have been suggested in the preceding chapter. In 
case the investigation yields a favorable report, they proceed 
to incorporate and capitalize the new enterprise in accord- 
ance with the principles previously discussed. The procedure 
thereafter differs. Some of the firms work in close connection 
with banking houses which underwrite the securities of their 
corporations and proceed to sell them to the general public. 
Other firms have their own departments or subsidiary cor- 
porations for the sale of securities, thus carrying through the 
whole enterprise from its inception through the investigation, 
the flotation, the construction of the plant or property, and 
even beyond this, through the initial stages of its manage- 
ment. 

German electrical companies follow much the same policy 
and in the international markets work in direct competition in 
this respect with American companies. It is said, however, 
that engineering firms in other countries have not developed 



254 SECURING CAPITAL 

as financial agencies to anything like the same extent as some 
of the American firms. 

Business Executives as Promoters 

In forming combinations among competing manufacturing 
plants, it is not at all unusual to find the initiative coming 
from the manufacturers themselves. Sometimes they get 
together and, through a committee or through informal dis- 
cussion, agree upon a plan of forming a new corporation 
which shall take in all the previously competing plants. This 
was the method of forming the leather, cordage, asphalt, 
and glucose combinations. In a case of this kind, we hardly 
speak of a "promoter." There is really not much need for 
his services, inasmuch as the manufacturers meet of their own 
accord. Another situation exists in some industries where 
there is keen competition and possibly some ill-feeling, but 
where one plant or one individual stands out as a recognized 
leader, either through size, enterprise, personality, or other 
cause. If a combination is to be formed in an industry where 
this situation prevails, it may be easily possible for the lead- 
ing firm or individual to become the promoter. This was 
true in the case of the salt, malting, and bicycle combina- 
tions. It constitutes a somewhat exceptional case when a 
business executive or a group of executives in one concern 
actually promote a combination with their rivals. The case 
is exceptional for the reason that no man easily submits to 
taking a position of inferiority to a former competitor or to 
seeing his competitor, starting from the same level as him- 
self, form a combination and take a large block of promoter's 
profits. It is far easier for a man to come in from out- 
side in order to carry through such a combination. 

The customary case of the business executive as a pro- 
moter arises in the formation of entirely new enterprises. 
The man who takes the lead in such enterprises, is com- 



THE PROMOTER 



^55 



monly the same man who expects to manage them after they 
are organized. In many respects this is the correct arrange- 
ment. It obviates the objection which arises when the pro- 
moter forms a combination and then ceases his active connec- 
tion with it; namely, that the promoter is influenced wholly 
by his desire to sell stock and float the new enterprise and 
not at all by consideration of the future requirements of the 
enterprise. On the other hand, when the future manager of 
the enterprise himself promotes it, there is the corresponding 
danger that he will overlook its financial needs while secur- 
ing his capital — if he is successful in getting it on any terms 
— by unnecessarily crude and wasteful methods. To be sure, 
the resulting loss is chiefly in the prospective profits of the 
promoter himself, so that no one else is likely to object. 
However, in the interests of men of this type, a few remarks 
as to points which they should watch in forming their financial 
plan will not be out of place. 

The Promoter's Financial Plan 

First of all, it is necessary that sufficient capital should 
be raised or authorized; yet, on the other hand, it is desir- 
able, if the period of construction and development is to be 
lengthy, that the sale of securities should be postponed until 
the corporation is actually on its feet. There may seem to 
be at first glance no possibility of reconciling these two con- 
flicting requirements. The solution to this problem is to be 
found in making such connections with banking houses that 
they will be willing to carry through the preliminary financing 
and underwrite the sale of the securities of the completed 
proposition. This is one of the devices universally used in 
large enterprises, but seldom in small ones. There is no rea- 
son, however, why it should not be almost equally well adapted 
to the small concern which through the local bankers may 
secure accommodation on the strength of its own securities as 



256 SECURING CAPITAL 

collateral and may later sell those securities and repay the 
bank loan. 

A second point to notice is that the promoter should pro- 
tect his own interests, for he may be sure that no one else 
will do this for him. The proper method of taking care of 
himself is to raise all the capital that is needed, on as good 
terms as possible, by the sale of bonds, preferred shares, 
and common shares, retaining for himself the remaining 
equity in the business. This is the place where many busi- 
ness executives, as promoters, fail to realize the full returns 
to which they are entitled. They are likely to put in their 
own money under precisely the same conditions as the money 
of other people, without reserving for themselves the equit- 
able interest which belongs to the promoter of the enterprise 
and which any other promoter would easily obtain. 

Promoters' Legal Status 

Legally the promoter is in a somewhat anomalous situ- 
ation inasmuch as he is acting as representative of an enter- 
prise which is, perhaps, not yet formed, or which, even if 
incorporated, is wholly a product of his own. The pro- 
moter's actions and promises cannot legally bind the corpora- 
tion, although the promoter, as an individual, may be called 
upon to see to it that arrangements concluded on behalf of 
the corporation are actually carried out. The promoter, 
furthermore, stands in a limited trust relationship to the cor- 
poration and to the holders of securities which he has sold. 
This trust relationship forbids him from making secret 
profits at the expense of the corporation. He may make 
reasonable open profits without objection; as for instance 
when he buys a given property which is essential to the 
corporation, at a known price, and transfers it to the corpora- 
tion at a known higher price. But, in case he should buy this 
same property and transfer it to the corporation, making a 



THE PROMOTER 257 

profit for himself without making known this profit, then he 
would be guilty of a fraud against the purchasers of the 
corporation's securities. 

Among innumerable cases that might be cited to illustrate 
this statement, the following description of a Florida land deal 
has been selected : 

In April, 191 1, five persons acting jointly as promoters of 
an enterprise, purchased 23,300 acres of land at $5.50 an acre 
— a total consideration of $128,150. On this contract they 
paid $5,000, the remainder to be paid at the rate of $2,500 per 
month. They then caused the incorporation of the "Southern 
Land Company" for $250,000, and entered into a contract with 
the new company under which they transferred the acreage 
above mentioned for $8 per acre. By further agreement, pay- 
ments were made by the new corporation direct to the original 
vendor of the land, so that the five promoters were relieved of 
all further trouble and responsibility. Their profits were to 
come in the form of final payments to them after the payments 
to the original vendor had been completed. Later, legal diffi- 
culties between the original vendor and the Southern Land 
Company arose, which made necessary the giving of notes by 
the land company and readjustment of their relations. There- 
upon the five promoters came forward with a proposition to 
the land company that they would transfer to the land com- 
pany their contract to purchase the land at $5.50 per acre. In 
consideration for giving up the difference between $5.50 and 
$8 per acre, they would accept $30,000 full-paid stock in the 
Southern Land Company. Objection was made to the trans- 
action on the ground that the promoters had no right to any 
profits whatsoever, inasmuch as they were acting, when they 
purchased the land, in a trust relationship to the corporation 
and to the later security holders. The prospectus of the South- 
ern Land Company stated that the land had been purchased 
at $8 per acre, but did not state from whom it had been pur- 



258 SECURING CAPITAL 

chased nor what profits had been made on the purchase by the 
promoters of the corporation. 

On the above statement of fact it seems there can be little 
question but that the promoters gave themselves profits to 
which they were not entitled. If the corporation had first 
been formed and an independent board of directors had been 
elected so that the promoters would then have had to deal with 
this board, it is probable that no legal question could have been 
raised as to any profits they might make. But in this instance 
they were dealing with a corporation which was completely in 
their own hands, and they appear clearly to have abused this 
relationship. 

Promotion Risks 

At the beginning of this chapter the case was mentioned 
of Seymour Scott who, having carried through two successful 
promotions, lost everything that he had made on both of them 
in an unsuccessful beet sugar promotion. Mr. Scott's experi- 
ence is not abnormal; on the contrary, the probabilities are 
that loss and failure in promotion is the ultimate result of 
fully one-half of the serious attempts to start new enterprises. 

There are, to be sure, classes of enterprise in which failure 
has become rare, as for example public utility corporations. 
The standards for estimating the probable income and ex- 
penses of such corporations have become so exact, and the 
estimating is now so carefully and scientifically done, that 
there is little reason to fear disaster. The chief risks in these 
enterprises are, first, the possibility of onerous regulation or 
partial confiscation of profits by governmental authorities; 
second, the possibility that the territory which they serve may 
decline in population and wealth. 

Other enterprises, particularly those engaged in manufac- 
turing and trading, are most apt to be shipwrecked through 
lack of careful calculation, foresight, and provisions for the 



THE PROMOTER 



259 



future. Yet, in addition to these probable causes of disaster, 
there are innumerable contingencies which cannot be foreseen. 
This is true of all business enterprises. In addition to the seri- 
ous risk that the new enterprise itself may prove to be unsuc- 
cessful and all the promoter's profits, represented in common 
stock, may be wiped out, there is the further risk to the pro- 
moter that he may fail to carry through the enterprise and 
may lose all his own expenditures of money, time, and energy 
devoted to its promotion. This may easily occur without any 
fault traceable to the promoter. The writer has in mind one 
instance in which a year's work, some tens of thousands of 
dollars of expenses and additional tens of thousands of dollars 
interested in options were lost to the promoter through the 
sudden death of one of the principals in a small combination 
which he was organizing. 

Besides the monetary loss, there is constantly a serious risk 
in promotion, even of the most legitimate kind, of damage to 
the promoter's business reputation. In order to attract capital 
he makes many recommendations, which he may believe to be 
thoroughly justified. If the enterprise is successful, the for- 
tunate purchaser of stock thanks his own excellent business 
I judgment and forgets that he was persuaded to accept the 
judgment of the promoter; if the enterprise is a failure, these 
same representations are likely to be used as material for legal 
and personal attack. After the disastrous failure of the United 
States Shipbuilding Company, there was a great deal of dis- 
cussion as to whether the real promoter was Colonel John J. 
McCook, a New York lawyer, or John W. Young, a New 
York banker. Colonel McCook was said to have employed 
auditors who investigated the value and earnings of the plants 
to be absorbed, and was also said to have introduced two of 
the principals in the new combination to each other. On the 
other hand, Mr. Young represented to certain of the vendors 
that he had employed the auditors ; and he was the only person 



2 6o SECURING CAPITAL 

who apparently possessed their detailed statement. It was 
claimed further that Mr. Young was the man who actually 
introduced the two principals just referred to. Dewing ex- 
pressed the opinion "that Mr. Young was the promoter and 
that Colonel McCook actively co-operated with him in floating 
the plan, but could not be considered responsible for certain 
misrepresentations."* 

The instance serves as a clear illustration of the point that 
an unsuccessful promotion necessarily carries with it some 
discredit to all who are connected with it, and particularly 
to the organizers of the enterprise. 

Promoters' Profits 

Earlier in the chapter some indication has been given of the 
customary method by which the promoter acquires his profits. 
The fundamental principle is that he is entitled to whatever 
remains of the capitalized value of the enterprise after the 
capital which it requires has been obtained. To make the 
practice entirely clear, let us take a simple hypothetical case. 
A promoter determines that a given manufacturing enter- 
prise will ordinarily earn, after it has completed a two-year 
period of development, in excess of $100,000 per annum net 
profits. If he is conservative, he will perhaps figure on creat- 
ing securities all of which will be salable at par on the fol- 
lowing basis: 

$500,000 6% first mortgage bonds $30,000 

$250,000 8% preferred stock 20,000 

$500,000 common stock yielding 10% 50,000 

Total capitalization ...... $100,000 

We will assume that the corporation actually needs 
$1,000,000 cash, and that the expense of investigation, secur- 



'Dewing's "Corporate Promotions and Reorganizations," p. 472. 



THE PROMOTER 2 6l 

ing options, incorporation, and selling securities amounts in 
total to $150,000. Under these conditions, the promoter 
would probably enter a contract to turn over $1,000,000 in 
cash, or possibly property and total assets for which he 
would actually pay $1,000,000, in exchange for all the bonds, 
preferred stock, and common stock of the corporation. He 
would then be able to sell bonds, preferred stock, and $250,000 
of the common stock, and would retain for himself $250,000, 
against which should be offset his expenses of $150,000. In 
other words, under all these estimates, his net profits would 
be $100,000, which would presumably be realized in common 
stock. 

Naturally the situation is not quite so simple in practice; 
nevertheless, the same principle can be readily applied of 
capitalizing prospective income and selling or exchanging all 
of the securities necessary in order to put the corporation 
on its feet, the remainder of the securities being left as the 
profits of promotion. There is, however, another complica- 
tion to be considered here, namely, the fact that a promoter 
very seldom works completely alone. It would, in all proba- 
bility, prove essential for him to secure the co-operation of 
certain bankers and of men who have some special knowl- 
edge or prestige, and he will be compelled to divide his profits 
with them. Quite frequently the original promoter builds 
up a more or less formal promoters' syndicate, of which he 
is manager, and which shares in whatever gain he makes. 

The principle that the promoter will accept as his com- 
pensation a portion of the final equity in the corporation is 
well established. Otherwise — in case, for instance, he insists 
upon receiving bonds or preferred stock — he reveals a lack 
of faith on his part in the success of the enterprise that 
would probably be fatal to his whole promotion scheme. 
This principle is applied in the United States freely, leav- 
ing to the promoter a block of the common stock. In Eng- 



262 SECURING CAPITAL 

lish practice another arrangement, which is in some respects 
preferable, has been common. In addition to bonds, prefer- 
ence shares, and ordinary shares, the organizers of a new 
corporation frequently cause to be created a final claim on 
the property, ranking after ordinary or common shares, this 
final claim being represented by "founders' " shares. The 
founders' shares ordinarily are entitled to dividends only 
after certain dividends have been paid on ordinary shares, 
after which they are entitled to participation in additional 
dividends. A favorite arrangement is to give the ordinary 
shares, say, 6% as their preference above founders' shares, 
and then to divide additional profits equally between ordinary 
shares and founders' shares. The founders' shares are usu- 
ally issued to a small nominal amount with a small par 
value to each share, often only one shilling. In a few in- 
stances where the companies have been phenomenally suc- 
cessful, the founders' shares have become extremely valuable, 
and there are even cases in which separate corporations have 
been formed in order to hold the total block of founders' 
shares and to sell interests in this block. The advantage of 
this English practice is that it defers promoters' profits until 
after those who have contributed cash have been fully 
protected. 

Illustrative Instances 

We may select from Dewing a few instances in corporate 
practice which will show just how promoters have secured 
their profits. 

In the case of the Mount Vernon- Woodberry Cotton Duck 
Company, the promoters had remaining in their hands 
$6,250,000 in common stock. Figuring its market value at 
$25, this amounted to a cash profit of well over $1,500,000. 
However, Mr. Parks, the chief promoter, was in no situation 
to keep all these profits for himself; they were divided to a 



THE PROMOTER 263 

great extent among the various mill-owners whose personal 
co-operation had been necessary. 

The United States Realty and Construction Company was 
incorporated in 1902 with a capitalization of $30,000,000 
preferred and $36,000,000 common stock. The five pro- 
moters, who included some well-known and highly respected 
citizens of New York, stated publicly that they would receive 
a profit for organizing the new corporation and for procuring 
the necessary working capital. The announcement was put in 
the following form : 

It is proper to state that we expect to receive for the 
responsibility and risks assumed by us in organizing the 
new corporation, procuring the cash capital, and for the 
expenses incurred, an individual profit which will or may 
include the stock of the new corporation remaining in 
our hands after carrying through the transaction. 

The promoters' profits in this case are calculated to have 
amounted to about $6,000,000 in common stock, or approxi- 
mately 10% of the total securities. At the outset the market 
value was about $1,800,000, and it had an average value dur- 
ing the first year of $720,000. 

In the promotion of the Glucose Sugar Refining Company, 
in 1897, a promoting syndicate was formed which received 
$100 in preferred stock and $142.85 in common stock, for 
every $100 subscribed in money. In accordance with these 
terms, the subscribers paid in $4,500,000 cash, and received 
$4,500,000 in preferred and $6,428,250 of common stock. In 
addition, the promoters got approximately $3,000,000 in com- 
mon stock for special funds, purchase money, bonuses, law- 
yers' expenses, and the like. The promoter, Joseph B. Green- 
hut, received direct a fee of $500,000 in common stock. Using 
the average quotation immediately after the formation of the 
combination, and omitting indirect profits, the promoters and 



264 SECURING CAPITAL 

underwriting syndicate appear to have obtained an immediate 
profit of $4,500,000. 

At the organization of the American Bicycle Company, in 
1898, the issues constituted $9,300,000 preferred, $17,700,000 
common, and $10,000,000 debenture bonds. For the constitu- 
ent plants the promoter paid approximately $6,700,000 in pre- 
ferred stock, $11,000,000 in common, and $7,230,000 in deben- 
ture bonds, leaving himself approximately $2,600,000 in pre- 
ferred, $6,700,000 in common, and $1,800,000 debentures. 
In spite of these enormous paper profits, Dewing says that 
after the promoter had paid the charges and commissions of 
bankers, attorneys, and others, there remained only a small 
profit for himself. 

At the formation of the American Malting Company, in 
1897, the amount left over for the promoters after the 22 
plants of the company had been purchased, and over $2,000,000 
of cash working capital provided, amounted to $500,000 of 
preferred stock and $7,750,000 common stock. This was out 
of a total of $12,500,000 preferred and $13,750,000 common. 

From all of the above instances, it is clear that successful 
promotion may carry with it very large profits, and yet we 
must not overlook expenses and risk which seem, on the 
whole, to make these profits reasonable. After a careful study 
of various promotions, Dewing comes to the conclusion that 
"the extravagant feature of a promotion is usually connected 
with the indirect rather than the direct profit." The pro- 
moter, after all, is probably entitled to what he gets. 



CHAPTER XII 

PROMOTING COMBINATIONS 

Development of Industrial Combinations 

Among the fields for promotive activities probably the one 
that has attracted the most public attention is the formation of 
combinations of previously existing companies. Most concerns 
are developed at the outset as isolated enterprises. At a later 
stage, however, nearly every expanding company comes into 
closer and closer relations with the concerns from which it 
buys and sells, and may even establish some financial con- 
nections with them. It is likely, also, to come into increas- 
ingly bitter competition with rival concerns, which competi- 
tion may either seriously cut its profits or may greatly limit 
the field of its operations. Thus, there exists an almost uni- 
versal tendency toward combination along one or both of the 
following lines : 

i. The first type may be called "vertical combination," 
which means the establishment of joint control over 
two or more concerns that are buying and selling 
from each other. 

2. The second type may be referred to as "horizontal 
combination," which means the establishment of 
joint control over two or more competitive con- 
cerns. 

Vertical combination is especially common between pur- 
chasers of raw materials, which may be wholly or partially 
monopolized, and the manufacturers of these materials. It is 
also common, on the other hand, between manufacturers who 
do not sell direct to the final consumers of their products and 

265 



266 SECURING CAPITAL 

some of the middlemen who intervene. The United States 
Steel Corporation is a notable example of a complete vertical 
combination, since it includes great iron-mining companies, 
ships and railroads for the transfer of ore, blast furnaces, 
manufactories of finished iron and steel products, and selling 
agencies, notably the United States Steel Products Company, 
which handles all the export selling. Here is a complete in- 
tegrated organization which carries on the whole process of 
mining, manufacturing, and selling. The United States Steel 
Corporation in some of its aspects also is a horizontal combi- 
nation. Examples of combinations between competing con- 
cerns are not difficult to find, and will readily occur to every 
reader. 

Naturally, the large combinations, with their hundreds of 
millions of dollars of capital, have attracted most attention. 
It is not always realized that the combination movement is 
going on also among comparatively small concerns, and that 
the aggregate importance of smaller combinations is probably 
even greater than the aggregate importance of the huge com- 
binations that have their securities listed on the stock ex- 
changes. The idea of taking over an interest in another con- 
cern, or the idea of forming a new corporation which shall 
hold control of two or more other concerns, is now entirely 
familiar and is being applied in hundreds of cases. In a great 
many of the smaller cities, manufacturers who have been op- 
erating on a comparatively small scale have in recent years 
combined their facilities. The remarkable growth of business 
associations made up of competitive manufacturers or traders 
has been a factor of importance in facilitating this movement 
toward small combinations. 

If the combination is purely a case of one concern purchas- 
ing a controlling interest in one or more other concerns, there 
is no distinct process of promotion. In cases, however, where 
a new corporation is formed to take over two or more previ- 



PROMOTING COMBINATIONS 267 

uusly independent corporations, promotion is an essential fea- 
ture of the arrangement. Some person, or group of persons, 
must conceive the combination, must carry on investigations, 
work out a financial plan, assemble their proposition, see to 
its preliminary financing, and finally dispose of the securities 
put out by the new corporation. The process of promoting a 
combination differs in many particulars from the promotion of 
a single enterprise, and in view of its importance is worth some 
separate study. 

Fields for Combinations 

We have spoken above chiefly of combinations among 
manufacturing concerns; and this is probably the field in 
which the tendency has in recent years been strongest. How- 
ever, it should not be forgotten that there are other fields 
for combination. Among the trading companies there have 
been a great many mergers or alliances of department stores 
and of groups or "chains" of small retail stores. Some- 
times these chains of stores have grown up in a very loose 
association, held together really by the personality of one or 
two men who are interested in each of the separate stores 
or plants. This loose association, it may be remarked, is 
especially common in the trade publication field, where one 
man will often possess a controlling interest in a number of 
trade papers, each one of which has its own separate cor- 
poration and organization. 

An example of a similar arrangement in the retail store 
field is the so-called Besse System Stores in New England, 
all of which are directed by L. W. Besse. There is a dif- 
ferent partner in each store. The management has already 
announced that this arrangement is not sufficiently stable and 
does not admit of scientific methods of administration; and 
presumably it will be replaced sooner or later by a single 
corporation which will be a combination of all the Besse 



2 68 SECURING CAPITAL 

stores. This is the manner in which loose associations of 
business interests usually develop into formal combinations. 
Much the same process has been gone through by the F. W. 
Woolworth Company and the Knox Company, both being 
owners of systems of chain stores. 

The movement toward combination has recently been 
strong among companies in the moving picture field. In 
19 1 3- 19 1 4, three film companies, with an aggregate capital of 
$1,500,000, were floated by a stock exchange house. At 
about the same time there was a $5,000,000 merger of three 
film-producing companies. In the early part of 1914, a 
$25,000,000 amalgamation was being talked of. 

Combinations among banks are also not uncommon; the 
great Continental-Commercial National Bank of Chicago 
being a noteworthy example. This tendency has been particu- 
larly prominent in English finance for the last twenty-five or 
thirty years. According to Huth Jackson, the number of 
individual banks in England and Wales declined from 366 
in 1887, to 133 in 1913; 209 banks disappearing through pur- 
chase or amalgamation. The tendency is successful because 
it produces stronger banks with a more diversified clientele, 
which are less likely to be swamped by local disturbances. 

Another field in which there has been a great deal of 
combination is among public utilities — including gas and elec- 
tric light and power companies, street railways, water works, 
irrigation works, and the like. Combinations in the public 
utility field are of a slightly different type from those in the 
manufacturing field. Usually they include a considerable 
number of local companies, each one operating in its own 
community, which communities may be far distant from one 
another. In fact, it is regarded as a point of strength if the 
various companies in a public utility combination are not 
affected by the same geographical or economic conditions, 
thus minimizing the danger that all of them may be seriously 



PROMOTING COMBINATIONS 269 

depressed at the same time. While a combination of this 
type may be classed as "horizontal," it is evidently made up, 
not of competing enterprises, but of enterprises which may 
profitably co-operate in such activities as the purchase of raw 
materials, securing high-grade engineering talent, comparing 
experiences, and the like. The great advantage, however, 
which the public utility combination has to offer is the fact 
that it can float bond and stock issues on a large scale and 
give them a national market, whereas the local public utility 
company experiences difficulty in selling its securities outside 
its local market. As a result, "about 78.5% of the total gas, 
electric light, and traction capital of operating public utilities 
is now owned by holding companies. The average electric 
light company has about $342,000 of securities outstanding. 
The undertaking is too small to finance itself efficiently when 
it has to increase its capital investment about 20% per annum ; 
that is why the holding company is efficient as a financial 
medium."* 

Difficulties in Forming a Combination 

Under the most favorable circumstances, the promoter 
does not lead an easy life. In investigating whatever prop- 
osition he has in mind, he must expend both money and time 
freely and it is quite likely that his efforts will be fruitless; 
he must exercise diplomacy and patience in securing his 
options or otherwise assembling his proposition ; he must pro- 
tect himself with the greatest care and forethought if he is 
to reap the reward of his efforts ; he must approach the owners 
of capital with a proposition which he believes to be favorable 
to them, and yet must be prepared for rebuffs and suspicion. 
These are the customary difficulties in promoting any enter- 
prise. 

The above difficulties are doubled or tripled when the 

♦Article by W. H. Gardiner in New York Annalist, June, 1915. 



270 



SECURING CAPITAL 



enterprise is a combination of previously independent con- 
cerns. And, if the combination includes concerns that have 
been previously competitive, the promoter is, first of all, con- 
fronted with the necessity of conciliating individuals who 
perhaps for years have been fighting each other with all the 
weapons at their command. Furthermore, the business in- 
terests of each separate concern going into the combination 
demand that it should make for itself the largest claims that 
it can reasonably support and should look with much sus- 
picion on the claims that are advanced by the other con- 
cerns. Unless the promoter is a man of much force and 
unusual tact, it is almost inevitable that the negotiations 
should break off as a result of mutual distrust. This has 
been the result again and again, even though every person 
interested may have fully recognized the desirability of the 
proposed combination for the common good of all. 

In addition to the questions and conflicts that arise in deter- 
mining the financial terms of the combination, the creation of 
a working organization for the combination is more than likely 
to break up all negotiations. If the promoter is a true diplo- 
mat, he will probably try to postpone consideration of the 
management's personnel until after previous questions have 
all been disposed of. Nevertheless, it may, at the last mo- 
ment wreck the whole project. The promoter must usually 
make up his mind between one of two courses : either he must 
bring in an outsider of high standing as the chief officer of the 
combination and give him discretion to pick the best men he 
can find, thus creating an efficient working organization, or 
he must "play politics" and choose the officers from the men 
whose influence he requires in order to form the combination. 
If he chooses the first alternative, he must make his appeal 
most strongly to the men who have capital invested and whose 
business sense will lead them to respect the necessity and jus- 
tice of the proposed course of action, even though it may 



PROMOTING COMBINATIONS 2 yi 

involve sacrifices on the part of some individuals. If he 
chooses the second alternative, he must make his appeal pri- 
marily to the active officers of the concerns that are to be com- 
bined, and must depend upon them to help him in influencing 
the owners of capital. Unfortunately, this second alternative 
is too often chosen, and is probably the direct cause of the 
breakdown of various combinations which should have proved 
highly successful. 

The writer has in mind one combination formed within the 
last five years, which is still running and on the surface appears 
to be prosperous. The officers, however, were all chosen 
because of their influence, not because of their abilities. The 
president was formerly the head of a small and efficient plant 
which v/as much needed in the combination. He is a good 
manager of a one-man plant, but is wholly without training or 
ability to control a large organization. The treasurer was the 
head of one of the larger companies absorbed in the combina- 
tion; he draws a larger salary than the president, yet has 
almost no active duties and devotes most of his time to other 
business enterprises. The vice-president is a relative of one of 
the bankers who helped to finance the combination. He is 
supposed to be one of the operating officials, yet he and the 
president are scarcely on speaking terms with each other. The 
other officers, including even some of those in subordinate posi- 
tions, were similarly chosen for political reasons. 

It seems scarcely possible that this particular combination 
should continue to exist much longer. Yet it may happen 
that an internal reorganization will be effected before it is 
too late, and thus the combination, which is probably basically 
sound, will after all, prove to be the success that was 
anticipated. 

The difficulties which have to be overcome in organizing 
a combination among long-time competitors may be illus- 
trated by recording the facts as to a recent attempt to 



272 



SECURING CAPITAL 



organize a combination in the publishing field, as told by one 
of those interested: 

An outside promoter was endeavoring to form the 
combination, but he was hampered by the fact that he 
is well known in the publishing field, and had had previ- 
ous business dealings with the owners of the separate 
companies. Most, if not all, of the men whom he 
approached regarded his arguments — whether justly or 
not is beside the point — with distrust. 

One of these men stated, for example, that the pro- 
moter was a man of the type who, having himself had 
several disastrous experiences, had decided that he had 
become an expert well qualified to tell more successful 
publishers how to conduct their business. 

Inasmuch as the proposed combination looked some- 
what attractive to all of the men approached, the pro- 
moter was able to arrange for a meeting of these men 
in his office. At this meeting, which was informal, the 
promoter presided and undertook to draw out expres- 
sions of opinion from each person present. No personal 
unfriendliness was manifest, and the meeting proceeded 
harmoniously enough, until the question of the price to 
be paid for each company taken into the combination 
was raised. At this point, naturally, it was difficult to 
reach any agreement, particularly as each one present 
was more anxious to draw out the others than to 
present his own ideas. 

If the promoter had commanded a great deal of re- 
spect, or even if he had been an outsider who was believed 
to be capable and impartial, he would have been able to 
put through some definite plan for appraising each of 
the companies interested. The truth was, however, 
that he had no more influence than any of the other per- 
sons present and his plan for appointing an appraisal 
committee, with himself as chairman, was coldly received. 
Inasmuch as no better plan was brought forward, the 
meeting finally adjourned without definite result and the 
same group of men were never afterwards brought to- 
gether. 



PROMOTING COMBINATIONS 273 

Preliminary Investigation 

Among the questions that should be fully and clearly 
answered before any combination of going concerns is 
attempted, are the following: 

1. What is the financial history of each concern that is 
to be considered as a possible member of the combination? 
How long has it been in existence? Is its organization stable? 
Are its earnings increasing or decreasing? Are adequate 
depreciation and other reserves deducted before estimating 
profits? Is the plant and physical property in good condition? 

2. Who are the men engaged in this industry who have 
shown the most enterprise and good judgment? Will they 
join in the proposed combination and work together on har- 
monious terms? Will it be necessary to give positions to 
incompetents or to make unfair concessions in order to in- 
fluence men who are essential to the combination? 

3. What, if any, advantages as a money maker will the 
proposed combination have over the separate, independent 
concerns? Will the combination be in violation of any laws? 
Will it be necessary to raise prices or otherwise incur any 
unpopularity in order to secure larger profits? Is it possible 
to introduce more efficient methods into the management of 
the various plants without arousing undue hostility at the 
beginning? 

4. Assuming that the combination is agreed to, what 
should be the financial plan of the proposed combination? 
Upon what basis can its securities be exchanged for the 
securities of the independent concerns? On what basis can 
other securities be underwritten and sold to the public? How 
much fresh capital will the combination need? Will there 
remain a block of securities sufficient to compensate all who 
took part in the promotion, for their respective risks and 
expenditures ? 

The questions above suggested are by no means exhaustive, 



V4 



SECURING CAPITAL 



but merely indicate the lines which the promoter will follow 
in his own preliminary investigation. If the promoter is him- 
self engaged in the industry in which the combination is to 
be formed, he will probably be familiar at first hand with 
the answers to most of the questions listed above. Neverthe- 
less it is unsafe for him to depend altogether on his personal 
knowledge, which will probably be inexact. The promoter 
must in any case proceed with much discretion and even with 
secrecy in gathering the preliminary information that he 
needs ; otherwise, he is likely either to arouse suspicion, which 
would interfere with his later plans, or to stir up premature 
discussion and arguments that might lead to personal dif- 
ferences or might even favor the promotion of rival plans. 

After the promoter, or his immediate associates if there 
is a group of promoters, have gathered all the preliminary 
information available, it will be possible to form a tentative 
plan indicating about what capitalization the proposed com- 
pany should possess, and what terms should be offered to 
all the concerns that are to be included. It is usually safe to 
assume that this tentative plan will be greatly modified 
during the progress of negotiations. 

The next step, usually, is to meet each of the parties whom 
he hopes to interest, in a separate, personal conference, go 
over the whole proposition, and, if possible, bring each con- 
cern into line to the extent of expressing interest and 
willingness to agree to some recent reasonable basis of com- 
bination. Usually it would not be considered necessary or desir- 
able to attempt to close definite contracts by this process of 
holding conferences with the separate interests. The final 
agreement should result after a general conference where the 
united views of all the participants in the combination will 
be expressed. 

However, it has already been pointed out that in the 
case of the Mount Vernon- Woodberry Company the pro- 



PROMOTING COMBINATIONS 



2/5 



moters proceeded to purchase outright a considerable num- 
ber of separate plants, and then went ahead with their finan- 
cial plans and their sale of securities to the public on their own 
terms. In other instances, options have been secured or 
definite contracts have been closed with the large indepen- 
dent stockholders in the constituent companies for the ex- 
change of securities. All these methods of promotion have 
been utilized at ,one time or another in order to obtain 
a complete mastery of the situation, so that no meeting of 
the various parties interested and no general agreement as to 
a basis of combination will be called for. 

In the usual and typical case, however, the next step after 
the promoter has assured himself of the favorable reception 
of the general plan, is to bring together the important repre- 
sentatives of interests that are to be included in the combina- 
tion, in an endeavor to reach an agreement regarding a basis 
of combination. 

Basis of Combination* 

In the promotion of the United States Leather Company, 
in 1893, the initiative was taken by certain manufacturers who 
mutually agreed upon the necessity of forming a combination 
and who carried through the whole project with very little 
outside advice or assistance, even on the part of bankers. 
After securing the agreement of the principal concerns in the 
leather industry to the general principle that a combination 
was desirable, the leaders of the movement proceeded to 
appoint committees for the purpose of appraising the physical 
properties of the independent concerns. It was agreed that 
the new company should issue $100 in preferred stock and 
$100 in common stock, in return for each $100 of the 
appraised value of the physical properties. In this way the 



*The statements in this section as to the leather and starch combinations are 
based upon the exceptionally able and graphic accounts contained in Dewing's "Cor. 
porate Promotions and Reorganizations." 



276 SECURING CAPITAL 

new corporation acquired approximately no tanneries con- 
trolled by 60 different leather houses, about 400,000 acres of 
bark land, and bark rights on 100,000 acres additional. This 
was a very simple basis of combination. The plan gave no con- 
sideration whatever to good-will, patents, contracts, and other 
intangible assets — or rather the plan assumed that these 
intangible assets were uniformly equivalent to the value of 
the tangible assets. On this basis, the new corporation 
acquired all the physical properties that it needed. 

The next problem was to raise working capital, which was 
secured through an issue of $10,000,000 debenture bonds, of 
which $6,000,000 were underwritten and issued at par. The 
underwriting syndicate in this case received $600,000 par 
value of common stock as a 10% commission for underwrit- 
ing. It is, of course, to be borne in mind that the common 
stock did not have a market value even approaching par, so 
that the actual underwriting commission was far below 10%. 

The later history of the leather combination was unfor- 
tunate, but this need not concern us here. The manner in 
which the combination w r as carried through and the agreed 
basis of combination seem, on the whole, to have been fair. 
The tanners who joined the combination considered the ap- 
praisals of their property just; outside tanners, however, criti- 
cized the appraisals on which stock was issued as being in all 
cases considerably inflated. 

The first consolidation in the starch industry was the 
National Starch Manufacturing Company in 1890. In this 
case the promoter, after making his preliminary investigation 
and forming his financial plan, secured options on twenty 
starch manufacturing plants. All the options stipulated that 
the vendors should receive 25% of the value of their mills in 
cash; 2>Z Z A% m bonds; 22^% in first preferred stock; and 
i8j4% in second preferred stock. In addition, each manu- 
facturer was to receive a common stock bonus of 27^2%. 



PROMOTING COMBINATIONS 277 

The working capital of each independent concern was taken 
over and paid for in cash. 

It was part of this general plan that the promoter himself, 
through a company of which he was president, should furnish 
$1,545,750 cash, for which he received an equal amount in 
bonds and preferred stock and 100% bonus of common stock. 
Assuming that the promoter was able to market these securi- 
ties at the prices prevailing during the first two years follow- 
ing the promotion, his compensation amounted to §722,677. 

It is evident that in this instance, although the promoter 
was acting on his own responsibility, there was a common 
basis of valuation and terms of payment for the plants which 
were turned into the combination. When securities are ex- 
changed it is, in fact, necessary that there should be some 
such common agreement — or at least an informal understand- 
ing — for otherwise there is no method of judging the probable 
value of the securities received in payment for the plants. 

In 1889 another promoter planned to organize a second 
starch combination, and a meeting was held in the office of 
Charles R. Flint of New York for the purpose of deciding 
upon the basis of combination. The minutes of this meeting 
have been preserved, and are extremely interesting as showing 
the first stages in the process of organizing a combination. 

Memorandum of Meeting held in the office of Charles 
R. Flint, June 30, at 10 a.m. 

Present: Messrs. Flint, Auerbach, T. P. Kingsford, 
Higgins, Duryea, Morton, and Allen. 

It is agreed to organize the United States Starch Com- 
pany with a capital of $2,500,000 preferred 6% cumulative 
stock and $3,500,000 common stock. And that the former 
shall be held in trust by the United States Mortgage and 
Trust Company, and issued later through bankers to be 
provided by Mr. Flint. The common stock shall also be 
held in trust for the owners for such a time as they 
may elect. 



278 SECURING CAPITAL 

It is agreed and understood that the vendors shall 
receive $950,000 in cash, $1,550,000 preferred stock, and 
$3,000,000 in common stock, for their plants and in- 
ventories, to be provided for as follows: 

First, a loan shall be made by the United States 
Mortgage and Trust Company for $950,000 for nine 
months, same to be paid from the proceeds of the sale 
of an equal amount of preferred stock to be issued at 
such time as in the judgment of the Directors may be 
proper. The proceeds of this loan to be used as follows: 

To pay Kingsford $400,000 

" " Morton 175,000 

" " Graves 350,000 

" " Duryea 25,000 



Total $950,000 

Second, in addition to the cash paid as above, pre- 
ferred stock shall be assigned to the vendors as follows: 

Kingsford . . . .$1,100,000 on plant and inventory 



Morton 


125,000 " 


plant 


Duryea . . . . 


100,000 " 


inventory 


" 


75,000 " 


plant 


Graves 


100,000 " 


inventory 




50,000 " 


plant 



Total $1,550,000 

which shall be held in trust by the United States Mort- 
gage and Trust Company for account of the owners until 
the time of issue. 

$3,000,000 of common stock is to be issued to the 
vendors in part payment of real and personal property 
turned over to the new company, as follows: 

Kingsford $2,422,500 

Morton 255,000 

Duryea 322,500 



Total $3,000,000 



PROMOTING COMBINATIONS 279 

Included in the property turned over by the vendors, 
it is estimated that there will be about $750,000 of quick 
assets, consisting of grain, package materials, and starch, 
manufactured and in process. 

$500,000 in common stock shall be paid to cover the 
entire costs of promoting the company, including the 
charter, the organization, the commission paid in stock for 
securing the loan, the fee of the bankers who issue the 
preferred. 

Common stock to vendors $3,000,000 

Common stock to promoters 500,000 

Total $3,500,000 

Typical English Combinations 

A noteworthy English combination, effected in 1914, was 
the acquirement of A. & F. Pears, Limited, manufacturers of 
Pears Soap, by Lever Brothers, Limited, manufacturers of 
"Sunlight" and other well-known brands of soap. A. & F. 
Pears had outstanding £320,000 ordinary shares, on which 
dividends of 12% had been regularly paid for some years. 
Under the terms of the combination, these ordinary shares 
were converted into 12%: cumulative preferred ordinary 
shares of the company of Lever Brothers, Limited, which 
rank next after its 5% debentures and 6% preference shares. 
A. & F. Pears, Limited, then increased their capital by issuing 
150,000 new ordinary shares, which were purchased by Lever 
Brothers, Limited, for £150,000. This £150,000 was then 
invested in Lever Brothers 15% preferred ordinary shares at 
par; the market value of these shares in normal times being 
about two and one-half times par. 

The purpose of this transfer evidently was two-fold : first, 
to give Lever Brothers all the voting shares in A. & F. Pears, 
Limited; second, to provide additional security for the con- 
tinued payment of the 12% dividends on the new preferred 
ordinary shares. In addition, A. & F. Pears, Limited, held on 



280 SECURING CAPITAL 

June 30, 19 1 4, investments in outside securities which had 
cost £220,390, but which showed a depreciation at that time 
of about £33,000. It was agreed that A. & F. Pears, Limited, 
should retain £94,843 of these securities which could be held 
as reserve funds to offset depreciation of the plant and of the 
leasehold on certain pieces of real estate. 

The balance, amounting to £125,547, was taken over by 
Lever Brothers in payment for which they gave to A. & F. 
Pears, Limited, Lever Brothers' preferred ordinary shares to 
the amount of £55,800, worth at the market value of £2 5s. per 
share, £125,550. The reason for this last transfer was not 
explained, but it may be presumed to have been intended to 
simplify the financial relations between the two concerns, and 
to provide still further security for the continued payment of 
the 12%. dividends on Lever Brothers' preferred ordinary 
shares. 

The principle upon which this combination is based is evi- 
dently that of assuring the stockholders of the absorbed com- 
pany that they are to continue to receive indefinitely the same 
rate of dividends which they had been receiving in the past. 
In other words, in exchange for the privilege of controlling 
A. & F. Pears, Limited, and for the chance of building up still 
higher profits, Lever Brothers were willing to assume all the 
risk of the undertaking. 

This type of combination is not at all unusual when one 
or two corporations are to be taken over by a previously ex- 
isting corporation of high credit standing. It is especially 
common in the United States in connection with the long-term 
leases much used by railroad companies. For instance, the 
New York Central Railroad Company leases the Boston and 
Albany Railroad Company for a 99-year term, the rental con- 
sisting of a guarantee of 8% dividends on Boston and Albany 
stock, plus the payment by New York Central of all organiza- 
tion expenses, taxes, and other possible deductions from Bos- 



PROMOTING COMBINATIONS 2 8l 

ton and Albany income. Similarly, the Western Union 
Telegraph Company leases the property of a subsidiary com- 
pany for a 50-year term, the rental consisting of a 5% payment 
on the stock. 

Consolidations 

Sometimes two or more formerly independent corporations 
are not joined under one control by an exchange of securities, 
but are actually "consolidated" or "merged." The two words 
just quoted are sometimes used in a popular sense as almost 
equivalent to "combined," but are here used in their legal sense. 
A "consolidation" or "merger," technically speaking, consists 
of the complete union of one corporation with another corpora- 
tion, so that the charters, corporate powers, and security issues 
are all combined, making only one corporation in place of the 
two which previously existed. This is entirely different, it will 
be seen, from the customary process of keeping alive all the cor- 
porations that enter into the combination and simply acquiring 
voting control over those corporations. A "consolidation" or 
"merger," in the technical sense, is somewhat unusual ; in fact, 
this form is very seldom used except when a railroad or other 
company desires to take over in toto one of its subsidiary com- 
panies which has previously been the legal owner of a separate 
piece of property. The largest and most important consolida- 
tion that has ever taken place in the United States was that of 
the New York Central and Lake Shore and Michigan Central 
Railroad Company in 19 14. The prime purpose in this case, 
it was stated, was to make possible a more extensive mortgage 
and larger bond issues than could be brought out by either of 
the corporations separately. 

This discussion of forms of combination is perhaps lead- 
ing us away slightly from the main topic of methods of pro- 
moting combinations, for such forms as are treated in these 
sections are customary only when the corporations concerned 



282 SECURING CAPITAL 

have previously been under common control. The combina- 
tion in such cases could hardly be regarded as requiring 
promotion. Nevertheless, a promoter sometimes brings about 
a combination of a small independent company with a large 
and powerful company by effecting a lease or a "consolida- 
tion" of the two. 

Analysis of a Small Combination 

In order to illustrate the principles treated in the chapters 
on promotion in a collected form, and to show how they may 
be applied in practice, it may be well to review briefly the 
facts as to a small combination of manufacturing plants 
located in a western city. 

The Western Machinery Company was organized in 1900 
for the purpose of manufacturing certain patented specialties. 
The capital stock was $150,000, and first mortgage bonds were 
issued to the extent of $25,000; $100,000 of the capital stock 
was given in payment for patents, and $50,000 was given to 
the first promoter for his services in disposing of the bonds 
at par. The $25,000 received for the bonds represented the 
total cash actually invested. 

It was quickly found that the business would not prosper 
with the few specialities that it had been arranged to manu- 
facture, and other specialties intended for the same general 
market were added. As a result, practically all of the profits 
which were earned from year to year were spent in securing 
new patents and in other development. This continued until 
1906, in which year a satisfactory profit was made. However, 
the crisis of 1907 and the depression that followed almost 
wiped out the business of the company and cut down the 
profits practically to zero. In the last two years, however, 
there has been a recovery and net profits are now running 
at the rate of approximately $20,000 per annum. The char- 
acter of the business has changed considerably since its in- 



PROMOTING COMBINATIONS 283 

ception, but it may now be regarded as established on a 
reasonably sound basis. The company, however, is consider- 
ably handicapped, its location being unfavorable for the kind 
of business it is now handling. 

A few miles distant from the city in which the Western 
Machinery Company operates is a related, but not competi- 
tive, business, owned outright by a gentleman whom we will 
call James Smith. He has a small plant worth perhaps 
$60,000, and is earning net profits of about $6,500. 

There is also in the immediate neighborhood the plant of 
a manufacturing company which became bankrupt some years 
ago. The plant has been closed for over three years. The 
buildings and other assets, even in their present depreciated 
condition, are estimated to have a value of well over $100,000, 
but could be bought for a much smaller consideration. 

The following plan for the combination of the three plants 
above described was recently under consideration : 

It is now proposed to combine these three plants under the 
name and charter of the first-named company, which is now 
carrying on an active and successful business. It is believed 
that the same management which has developed this business 
in the face of unfavorable conditions can at least go ahead 
with the successful operation of the plant owned by James 
Smith and can reorganize and successfully conduct the 
abandoned business of the company which formerly owned 
the third plant above named. James Smith is willing to re- 
main with the new organization for a short time and then 
retire, so there are no personal antipathies or jealousies to be 
overcome. It is proposed to recapitalize the Western Ma- 
chinery Company as follows: 

Authorized Issue Actual Issue 

6% First Mortgage Bonds $500,000 $150,000 

6% Cumulative Preferred Stock. . . 250,000 180,000 

Common Stock 250,000 250,000 



284 SECURING CAPITAL 

It is proposed to distribute these securities as follows: 



Bonds 

Western Machinery Company $30,000 

James Smith 

Owners of abandoned plant 20,000 

To be sold to the public 100,000 



Preferred 


Common 


Stock 


Stock 


$100,000 


$250,000 


20,000 




40,000 




20,000 





Total $150,000 $180,000 $250,000 

It is anticipated that the bonds, with a 20% bonus of pre- 
ferred stock, can be sold to an underwriting syndicate at par. 
The syndicate will probably be able to dispose of the bonds 
alone at par, leaving its selling expenses and profits to be 
covered by the bonus of preferred. Thus the company will 
realize $100,000 in cash. 

It is further provided in the financial plan that James 
Smith shall receive in addition to his $20,000 preferred, 
$30,000 in cash, thus leaving $70,000 for rehabilitation of the 
abandoned plant and for working capital. 

It is further provided that when earnings on the preferred 
stock amount to as much as 12%, then the 70% of preferred 
remaining unissued at the time of organization shall be dis- 
tributed as a bonus in agreed proportion among the owners 
of the three plants entering into the combination. 

It is estimated that the net profits of the combination 
should average at least $60,000, or approximately three times 
the interest and preferred dividend payments, at the outset. 
The three lines of business, it is stated, fit together splendidly 
and the combination of the different businesses will provide 
excellent facilities for manufacturing and shipping which will 
much improve the efficiency of the two going plants and will 
make possible the profitable operation of the abandoned plant. 

In an independent analysis and criticism of the plan above 
set forth, it was pointed out that the earnings of the pro- 



PROMOTING COMBINATIONS 285 

posed combination appear to be loosely estimated and that 
a much more thorough investigation of probable markets for 
the products of the combination, of the selling expenses, and 
of the actual expenditures required to build up an efficient 
working organization in the abandoned plant, would be 
demanded by a conservative investor before putting any of 
his money into the proposition. Unless it can be demon- 
strated, not merely as a supposition, but as a reasonable 
certainty, that the earnings will average $60,000 or more, 
there will be no real advantage to the Western Machinery 
Company in carrying through this combination. After all, 
the plant which they possess is the only one that is now earn- 
ing a considerable volume of profits, and this plant will 
presumably be the chief contributor to the profits of the com- 
bination. 

It is no doubt true, as stated, that the Western Machinery 
Company could make use of enlarged facilities advantage- 
ously, but the question to consider here is whether a small 
bond or preferred stock issue, based upon the assets of the 
company, would not provide facilities for enlarging its opera- 
tions and earning more profits with less risk than would be 
the case if they carried through the combination. Under 
the proposed plan, the Western Machinery Company assumes 
nearly the whole burden of risk, must contribute its own 
profits to the payment of interest and dividends, and must 
rely on its ability to develop new business for the other two 
plants in order to give a satisfactory return to the present 
owners of the Western Machinery Company. To state the 
case in slightly different terms, the most successful of the 
three companies entering into this plan will be giving up the 
practical certainty of continued, satisfactory profits, for the 
uncertainty of developing a new enterprise. 

It may be stated in general terms, that the wisdom of 
combining a going, successful concern with an unsuccessful 



2&6 SECURING CAPITAL 

concern may almost always be questioned. If the successful 
concern desires to acquire the assets of the unsuccessful con- 
cern, that may best be done by raising cash upon its own 
credit and purchasing those assets outright. The situation is 
entirely different from the one which exists when two or 
more going and successful corporations are combined on the 
basis of their earning powers. 

On the strength of this criticism, it was agreed that the 
plan was in all probability faulty, and it is understood to 
have since been abandoned.* 

Forming a Combination to Secure Control 

It sometimes happens that the promoters of a combina- 
tion have in mind, not so much the immediate cash profits 
which they may realize from combining and recapitalizing 
certain properties, as the ultimate profits which they may 
realize through obtaining control of the properties. If two 
or more companies are already capitalized at a high figure, 
it may be difficult to put through an exchange of securities 
that will realize much profit; yet the object of securing con- 
trol with a very small expenditure of cash may be attained. 

One of the most remarkable illustrations of this type of 
combination is the Rock Island Company, which in 191 5 went 
into a receiver's hands. The original company was the 
Chicago, Rock Island and Pacific Railway Company of 
Illinois, which up to 1901 had outstanding capital shares 
amounting to $50,000,000. In 1901 a controlling interest 
was acquired through the open market by a group which came 
to be known as the "Rock Island Crowd" made up of W. 
H. Moore, Daniel G. Reid, William B. Leeds, James H. 
Moore, and some minor participants. With the exception 
of Mr. Leeds, none of these men had had any special experi- 



*As the facts cited in this section are not matters of public record, the names 
and some of the identifying details are altered. 



PROMOTING COMBINATIONS 287 

ence or interest in railroad affairs. Their activities in Rock 
Island were almost wholly in connection with its finances. 

In June, 1901, within three months after they had secured 
control, the capital stock was increased from $50,000,000 to 
$60,000,000, the new shares being sold to the public at par. 
In 1902 the authorized capital stock was again increased to 
$75,000,000 and the new shares sold at par. This $25,000,000 
was used to construct and buy small lines or "feeders" for 
the railroad. 

Shortly afterwards a new corporation, the Chicago, Rock 
Island and Pacific Railroad Company of Iowa, was organized 
with an authorized capital stock of $125,000,000, and an 
authorized issue of collateral trust bonds of $75,000,000. 
The collateral trust bonds were exchanged, dollar for dollar, 
for the outstanding capital shares of the Chicago, Rock Island 
and Pacific Railway Company. 

At about the same time another new corporation, the Rock 
Island Company of New Jersey, was incorporated and at once 
issued $96,000,000 of common and $54,000,000 of preferred 
shares. This $150,000,000 was exchanged for the capital 
shares of the Chicago, Rock Island and Pacific Railroad 
Company of Iowa. A peculiarity of the Rock Island Com- 
pany of New Jersey was the fact that the preferred stock 
elected a majority of the board of directors. Hence, con- 
trol of slightly over $27,000,000 of the $54,000,000 outstand- 
ing preferred stock would give control of the corporation. 
Inasmuch as the preferred stock sold below par in the open 
market, the actual cash investment required was $16,000,000 
to $17,000,000. As the stock was good banking collateral, 
a large part of this investment could be borrowed. 

It is evident that the Rock Island Company controlled the 
Chicago, Rock Island and Pacific Railroad Company of Iowa, 
which in turn had control of the Chicago, Rock Island and 
Pacific Railway Company of Illinois, the operating corpora- 



288 



SECURING CAPITAL 



tion. In other words, a relatively slight cash investment 
would be sufficient to control a corporation having stock out- 
standing of a book value of over $75,000,000. 

The manner of holding control of the various corporations 
included in this remarkable scheme, is graphically shown 
below : 



Cash Investment 

Required 

$16,000,000 to $17,000,000 



Necessary for Control 
$27,000,000 Preferred of the 



Rock Island Company (of New Jersey) 

Capital Shares 

Common $96,000,000 

Preferred $54,000,000 

This Company owned all the capital shares of the 



Chicago, Rock Island and Pacific Railroad Company 

(of Iowa) 

Capital Shares $125,000,000 

Collateral Trust Bonds 75,000,000 

This Company had in its treasury all the capital shares 

of the 



Chicago, Rock Island and Pacific Railway Company 

(of Illinois) 

Capital Shares increased to $75,000,000 



The later history of this combination and its ignominious 
end are discussed in later chapters. 



PROMOTING COMBINATIONS 289 

Making Combinations Successful 

It may be remarked, in closing this chapter, that the 
history of many of the large industrial and of some of the 
large railroad combinations does not support the notion prev- 
alent some years ago that combinations necessarily achieve 
economies and improvements in management. On the con- 
trary, the general impression which today prevails among 
conservative bankers and investors is that most combinations 
suffer from recklessness and inefficiency of management. It 
is clear that when the executive organizations of a number 
of different plants are suddenly disrupted, and a new execu- 
tive organization takes over at one time the management of 
all these plants, there are pressing and difficult problems to be 
solved. The controlling spirits of the new management must 
be thoroughly trained and resourceful if they are able to 
retain the good features of the former managements and also 
add other good features which their larger capital will enable 
them to command. 

Sometimes a combination is formed under auspices so 
favorable and with so much harmony that a majority of the 
executive talent engaged in the former independent concerns 
remains with the combination. If the leader of the combina- 
tion proves to be a man of unusual breadth and of com- 
manding abilities, he may be able quickly to build up a new 
organization which will be highly efficient. Ordinarily, how- 
ever, it happens that the executive officers of the former 
independent plants, who are, perhaps, not large shareholders 
in those plants, are not satisfied to accept subordinate positions 
in the combination. They prefer to go into other lines of 
business or even to start competing concerns of their own. 
The malting combination and the various starch combina- 
tions are prominent examples. They were formed to limit 
and forestall competition; their chief result was to increase 
the amount and intensity of competition. 



290 SECURING CAPITAL 

On the other hand, this difficulty does not necessarily 
arise when a combination grows gradually by absorbing one 
or two plants at a time. In that case, the executive organiza- 
tion may also expand accordingly and the concern will be 
built on a safe basis. 

It may further be noted that the possibilities of directing 
an immense enterprise through the creation of a proper form 
of organization and other scientific methods of standardizing 
and testing the various activities, are only in process 
of development. When the principles of organization are 
better understood and more commonly applied, the obstacles 
to the success of combinations will tend to disappear. 



CHAPTER XIII 

SELLING SECURITIES DIRECT 

Four Methods of Selling Securities 

When a corporation is organized, and usually from time to 
time during its life, it is necessary to dispose of some of its 
securities. The initial capital must, of course, be raised by the 
sale of securities ; subsequent capital may come either by savings 
out of profits or by fresh sales of securities. We shall take up 
for review, in the order named, the four methods of sale com- 
monly used : 

i. Allotment to insiders or to previous shareholders. 

2. Direct sale to the outside public. 

3. Sale to banking houses, which in turn dispose of the 

securities by direct sale to the outside public. 

4. Sale to banking houses or brokerage houses, which in 

turn dispose of the securities through the machinery 
of stock exchanges. 

By the term "insiders," as used above, are meant all those 
who are themselves familiar at first hand with the affairs of a 
corporation and are either active in, or closely connected with, 
the management of the corporation. The term is not used in 
any derogatory sense, but merely as a convenient designation 
for those who have intimate relations, so to speak, with the 
concern. In very small or closely held corporations — assuming 
that there is good feeling among- the various persons interested 
— it is customary to allot securities as they are issued, to all 
those actively interested under some kind of mutual agreement. 
The universal rule of law is that, where new voting shares are 
issued by an established corporation, every voting shareholder 

291 



292 



SECURING CAPITAL 



must have an opportunity to take up a proportion of the new 
shares equivalent to his proportion of the shares previously 
outstanding. Unless there is some recent or mutual agreement 
to the contrary, it is generally found advisable in close cor- 
porations to allot new issues of common stock on this basis. 
Preferred stock or obligations are more likely to be sold to 
outsiders. There seems to be nothing more that requires ex- 
planation in connection with this very common situation. 

Establishing Cordial Relations with Shareholders 

Corporations already established and going ahead success- 
fully which require fresh capital from time to time for expan- 
sion of their activities, find it highly profitable to spend some 
thought and energy in cultivating the active good-will of their 
shareholders. This remark applies especially to companies 
which have a considerable number of shareholders, most of 
whom are not in close touch with the management of the 
business. The man who has invested some of his money in the 
stock of a corporation is likely to feel a certain personal interest 
in the continued success and growth of the corporation; he 
usually likes to be considered, not as a complete outsider, but 
as a person who is entitled to some special information and 
some privileges. Having once invested in the corporation and 
having come to follow its fortunes for that reason with more 
than usual interest, he is peculiarly approachable, if he is kept 
in an interested frame of mind, when a proposition to make a 
further investment is brought before him. In the language of 
salesmanship, two steps — making a favorable approach and 
arousing interest — have already been taken. The corporation 
presumably possesses his confidence. The succeeding steps — 
creating a desire to invest further and securing his decision to 
do so — should be comparatively easy if he is in a position to 
make further investments in anything. 

The idea of deliberately setting to work to cultivate the 



SELLING SECURITIES DIRECT 293 

friendship of the body of shareholders not identified with the 
management, may be regarded as a recent development in busi- 
ness finance. Even yet, there are comparatively few corpora- 
tions which have grasped and consistently apply the idea. The 
tendency still persists to regard the average stockholder — 
usually unknown personally — as merely a name which some 
clerk enters upon the books. We may go a step farther and 
say that in many corporate offices he appears to be regarded 
as an unavoidable nuisance who insists on draining away with 
his dividend checks — if he is fortunate enough to get them — 
the earnings which the officers and directors would much prefer 
to retain for themselves. The truth is that the average stock- 
holder is a human being who likes to be treated as such and 
who will respond, to a reasonable extent, if the corporation's 
relations with him are handled with fairness, courtesy, and 
some degree of cordiality. 

When the stockholders of the Northern Pacific Railroad 
Company received their dividend checks in the early part of 
191 5 from J. P. Morgan and Company, fiscal agents of the 
company, they were at least mildly surprised to find enclosed 
an advertising statement as to a trip to the Yellowstone 
National Park, which the railway company was promoting, and 
a return post card on which the stockholder could inquire for 
details as to the trip. 

The National Biscuit Company not long ago sent out to 
their stockholders a "Pandora Box" which contained samples 
of many of the company's products. The Loose-Wiles Biscuit 
Company has followed their example. Swift and Company 
furnish their stockholders, not merely with a formal annual 
report, but with a "Year Book" which contains a more intimate 
review of the internal workings of the company and incident- 
ally recommends that the stockholders purchase some of the 
company's products. The American Tobacco Company re- 
quests stockholders not only to call for the company's brands 



294 SECURING CAPITAL 

of tobacco, but to recommend their use to others. The United 
States Rubber Company sends to its stockholders a four-page 
folder urging them to use United States tires on their auto- 
mobiles.* 

A possible motive for the advertising efforts above noted 
is to increase the sale of the products of these corporations; 
but it is probable that a more important motive is to cultivate 
the good-will of the shareholders and increase their friendly 
interest in the corporation whose shares they hold. Corpora- 
tions which work along these lines may safely count on finding 
their shareholders more responsive the next time a new issue 
of securities is offered to them. 

Establishing Cordial Relations with Customers and Em- 
ployees 

In discussing this subject of relations with shareholders, 
it is convenient — although it might logically come a little later 
— to treat the subject of relations with employees and with cus- 
tomers. The modern corporation with broad-gauged manage- 
ment is no longer inclined to treat its employees or customers 
as if they were outsiders entitled to no special consideration. 
On the contrary, a direct conscious effort is continually being 
made to bring them into sympathy with the point of view of 
the management and, whenever possible, to persuade them to 
participate actively as shareholders in the risks and profits of 
the business. 

Some 25 years ago, when the Emerson Drug Company 
first put Bromo Seltzer on the market, its distribution 
was stimulated by giving a share of stock in the com- 
pany with purchases of a certain quantity of the product 
.... and the Bromo Seltzer business was a success as 
everybody knows who has any contact with the drug 
trade.f 



*The above examples were cited in an editorial in Printer's Ink, March 4, 1915. 
|From an article in Printer's Ink of June, 1915. 



SELLING SECURITIES DIRECT 



295 



Many other companies have since followed this example ; 
but ordinarily they have made the mistake of promising ex- 
travagant returns which they were not able to realize and 
consequently the whole plan has, to some extent, fallen into 
disrepute. However, the basic idea of tying up the interests of 
customers in some degree with the sale of the company's 
products is not unsound. 

In a field which is entirely unrelated, we see the same plan 
adopted by one of the great public utility corporations of the 
United States — the Pacific Gas and Electric Company. The 
report of this company for the year ended December 31, 1914, 
states that a campaign to induce its customers to become further 
interested in the operation of the company by purchasing first 
preferred stock had been successful, $4,000,000 of this stock 
having been taken up by customers and over $500,000 addi- 
tional by employees. In the first six months of 191 5, an 
additional $1,800,000 of the stock was sold to 1,069 customers. 
These last figures show that the stock is being widely distrib- 
uted in small blocks. 

It is clear that one result of this policy must be to secure 
a higher degree of local public interest and to strengthen the 
bonds which unite the corporation in friendly relations with 
the communities which it serves. 

The same idea is sometimes used by local enterprises. The 
Twin City Ferry Company of New York recently sent out 
a circular letter which begins as follows: 

This Company has some stock to sell (not much) and 
realizing the advantage of having our patrons interested 
in the profits of the business, I am writing some of the 
people who use the ferry and consequently know its 
value. 

The idea has been used again with success in securing new 
capital for extending a moving picture theatre. In all proba- 



296 SECURING CAPITAL 

bility the policy of appealing to customers and prospective 
customers could be applied advantageously in thousands of 
other enterprises. Many an owner of a small business who 
chafes helplessly against his "lack of capital" and blames the 
"trust" for his poor success, could obtain all the capital he 
needs if he would work out a sound proposition and present it 
by letter or in person to the people who are already interested 
as his customers. 

The sale of stock of a corporation to its employees is 
usually regarded as a device for profit-sharing and as funda- 
mentally a method of cultivating the good-will of employees 
rather than a method of raising capital. This is, in fact, usually 
the case, and yet we need not overlook entirely the other phase 
of the transaction. As an example of an excellent presentation 
of an offer of stock to employees, we cannot do better than 
quote below from a singularly effective circular sent out in 
March, 19 14, by Charles E. Murnan, Secretary of the United 
Drug Company. This company is a co-operative corporation, 
the stock of which is owned by a large number of drug shops 
throughout the United States. The circular from which the 
following quotation is extracted was addressed to drug-shop 
owners who are stockholders in the United Drug Company, 
with the request that they bring it to the attention of their 
clerks : 

What is here presented is, beyond question, the 
greatest force for good to your business and ours that 
has ever been set in motion. It will aid you in keeping 
good men when you find them because they have an 
interest to bind them. 

Our 7% Preferred Stock has been sold for a long 
time at $55 a share, that is, $110 for two share lots. 
Its intrinsic value is a great deal more. I have induced 
our Board of Directors to set aside a block of this stock 
to be sold to your store managers and clerks at its 
market price, $55 a share, and allow them to use the 



SELLING SECURITIES DIRECT 

checks enclosed as part payment, as per terms on back 
of checks, which will give it to them at par, $50, and 
besides they may pay for it by saving a little each week. 
Each check is good for $10 credit on each subscription 
for two shares ($110). They have ten months in which 
to pay for it at the rate of $10 on the tenth of each 
month. The same terms apply to each two-share lots 
subscribed for. For instance, if an employee wants six 
shares ($330), he would use three $10 checks for a credit 
of $30 on the whole and pay $30 a month, etc. Subscrip- 
tions and credit checks may be sent at once; cash pay- 
ments begin April 10. 

I know what a clerk thinks about, because I have been 
one. I know what a salary alone means, because I have 
been in that position. You may have been there also. 
As long as salary is the only incentive, a clerk will work 
for little else. You say this is not so in your case, be- 
cause you have good fellows who are loyal and do the 
very best they can. No man does the best he can. Each 
little incentive is additional motive power to his effort 
and, there being no corners on inspiration, therefore no 
limit can be reached. You cannot get the best that is in 
a man unless he looks at life on a bigger scale. Real 
work and worth are the result of ambition — ambition 
to do better and be more. 

Anybody who saves will give better service and that 
is what you need in your business. A man's heart is 
where his interests are. This inducement is given to make 
your employees take more interest in your business. They 
will get it only if they agree to save it and add more to 
it. We want them to have an interest in this great 
organization just as you have, if only a small one. We 
are willing to do something for them if they will do 
more for you and they will do it. Put this proposition 
up to them and let them decide. They are indebted to 
you for it because you have made it possible. 

You may say to this that $110 does not amount to 
anything, that it is not enough to stimulate interest or 
additional loyalty or anything else. You are absolutely 
wrong about it. Fortune has never yet been able to 



297 



298 SECURING CAPITAL 

establish a standard. Life is comparative. One hundred 
and ten dollars to some people is as much as a million 
to others. I know when I was working in a store, if 
somebody had given me a chance to get some stock in 
one of the biggest organizations in the world, I would 
have been the proudest fellow in my town. 

Note the informal tone of Mr. Murnan's circular and the 
skill with which he appeals to the interests of the proprietors 
who should be pleased to have their employees invest in the 
United Drug Company's stock. It is a thoroughly legitimate, 
effective plan for accomplishing two results : first, disposing 
of a certain amount of stock at a fair price ; second, enlisting 
the increased interest of a class of men who can do much to 
increase the sale of the company's products. 

While it is true that proper relations with shareholders, 
customers, and employees should be carefully cultivated in 
order to be in position to secure their co-operation and to sell 
them securities from time to time, there is grave danger in a 
practice which some concerns have been guilty of, viz., that of 
utilizing their lists of shareholders and customers in an en- 
deavor to sell them the securities of other companies. In 
1914-1915 an important correspondence school was subjected 
to bitter attacks and to serious injury because it was found that 
its prestige as an educational institution had been used in order 
to permit its officers to dispose of stocks of various enterprises 
in which they were personally interested. 

Grant of Subscription Privileges or "Rights" 

Corporations are not authorized, except under unusual cir- 
cumstances, to sell shares of stock below par. There is, 
however, no legal objection — again with minor exceptions — 
to selling shares which may have a market value higher than 
par, at par or at any price above par. The law looks only to 
the formal, theoretical requirement that the nominal value of 



SELLING SECURITIES DIRECT 



299 



a share of stock shall correspond to the amount of cash or 
property received in payment therefor. 

It follows that, whenever the stock of a corporation has a 
market value well above par, the corporation may issue shares 
below the market value and give a privilege, which is valuable 
to their previous shareholders, to purchase the new issues of 
stock at some arbitrary price well below their market value. 
The grant of a subscription privilege or "right," as it is 
customarily called, is one of the highly valued perquisites of 
stockholders in large and successful enterprises. 

There are at least three possible objects that may be in the 
minds of the directors of a corporation when they decide to 
grant a subscription privilege to their shareholders : 

1. It may be their chief object to raise additional capital 

by the sale of more stock in the easiest and least 
expensive way ; in which case the subscription privi- 
lege will probably name a price not many points 
below the market price of the stock. 

2. The directors may desire to give a special concession 

in the nature of a dividend to their stockholders at 
the same time that they raise some additional capital. 
In this case the subscription price will probably be 
fixed at a margin of several points below the market 
price. 

3. The directors may wish to increase the outstanding 

stock of the corporation more rapidly than the earn- 
ings are increasing ; in other words, they may desire 
to "water" the capitalization to a moderate extent, 
and at the same time to raise some additional capital. 
In this case the subscription price is likely to be far 
below the normal market price. 

Of course, it is common to find these three motives mixed 
in varying proportions in the directors' minds. It is clear. 



3°o 



SECURING CAPITAL 



however, that in either case one consideration is the belief that 
fresh capital can be advantageously used in the enterprise. 
For that reason, we will consider the subscription privilege in 
this chapter as if it were primarily a means of securing fresh 
capital. It will be referred to in its other aspects in later 
chapters. 

In the remarks above, it has been assumed that the sub- 
scription privilege is given exclusively to common shareholders 
and applies to additional issues of common shares, which is the 
ordinary situation. However, it is not at all the necessary 
situation. Under some exceptional conditions — depending on 
the terms of their contract with the company — the preferred 
shareholders may enjoy some subscription privileges. Further- 
more, the privilege may be granted not only in connection with 
the purchase of new common shares, but in connection with the 
purchase of new preferred or of obligations. 

Following is the form in which a "right" was granted some 
years ago to shareholders in the Union Pacific Railroad Com- 
pany to subscribe at 90% 'for 4% convertible gold bonds of the 
company, the market price of which was somewhat above 90 : 

Warrant 
$ No 

For Subscription to 
Twenty- Year 4% Convertible Gold Bonds 

Union Pacific Railroad Company 
Office of the Treasurer, 120 Broadway 

New York, N. Y., May 31, 1907. 

This is to Certify that , 

or assigns, is entitled to subscribe at 90% for 

dollars, face value of the Twenty- 
Year 4% Convertible Gold Bonds of Union Pacific 
Railroad Company, to be issued in accordance with 



SELLING SECURITIES DIRECT 301 

resolutions of the Board of Directors adopted May 9, 
1907, upon surrender hereof, at this office, on or before 
July 10, 1907, and subject to the adoption of a proposed 
amendment of the articles of incorporation of the Com- 
pany at a special meeting of the Stockholders called to 
convene June 15, 1907. 

Payment of such subscription must be made as 
follows : 

Per Per 

$1,000 bond $500 bond 

At the time of making sub- 
scription, on or before 
July 10, 1907 $200.00 $100.00 

On or before August 9, 1907. . 200.00 100.00 

On or before September 10, 
1907 (which includes ad- 
justment of accrued in- 
terest) 50542 252.71 

Subscriptions may be paid in full at the time of mak- 
ing subscriptions, on or before July 10, 1907, in which 
case the amount payable will be $901 per $1,000 bond, 
or $450.50 per $500 bond, including accrued interest. 

This warrant must be returned to this office on or 
before July 10, 1907, accompanied by the payment of the 
first instalment; and if not so returned with such pay- 
ment on or before said date will be void and of no value. 

Failure to pay the second or third instalments when 
and as payable will operate as a forfeiture of all rights 
in respect of the subscription and the instalments previ- 
ously paid. 

On the back of this warrant are two forms : the 
first to be signed when subscription is made, and the 
second, which is an assignment requiring a witness, to 
be signed if the privilege is disposed of. 

Treasurer. 

The reverse side of the preceding form appeared as follows : 



302 SECURING CAPITAL 

Subscription 

• 1907- 

Treasurer, Union Pacific Railroad Company, 

The undersigned hereby subscribes for the amount 
of bonds covered by this warrant. 

(Signature) 

(Address) 



Assignment 

1907. 

Treasurer, Union Pacific Railroad Company, 

For value received, the right to make the within sub- 
scription is hereby assigned to 

whose address is 

( Stockholder) 

(Address) 

Witness : 

( Signature) . '. 

(Address) 

Note : For estates or trust accounts this assignment must 
be executed by all the executors, administrators, or 
trustees. 

These "rights" when given in large corporations, are al- 
ways transferable. They are issued as formal documents which 
have the general appearance of a stock certificate and are 
passed from hand to hand by indorsement in blank on the back, 
in the same manner as a stock certificate ; consequently, these 
"rights" are bought and sold with the same facility as other 
kinds of desirable property. 



SELLING SECURITIES DIRECT 



303 



Objections to Subscription Privileges 

The basic objection to the granting of subscription privi- 
leges is the same objection which applies to all special dividends 
or bonuses — they inevitably give a speculative character to 
stock which might otherwise tend to enter the class of invest- 
ments or semi-investments. A stock receives a dividend, let 
us say, of 8% per annum, and this dividend has been continued 
over a series of years and is protected by an ample margin of 
earnings ; naturally the shareholders may look forward with 
some confidence to the period when the dividends will be 
increased to a normal level of 10% or 12%, and in view of 
this expectation the stock will probably sell at a high figure. 
We will suppose, however, that the directors, in place of build- 
ing up a surplus and getting ready for regular 10% dividends, 
decide to grant a special subscription privilege worth $5 to $10 
per share, in this way increasing the amount of capital stock 
upon which dividends must be paid and making it impossible 
to expect more than the indefinite maintenance of 8%. divi- 
dends. What will be the result? The shareholder, to be sure, 
will have obtained his subscription privilege, which is desirable, 
but he will have lost perceptibly in the market value of his 
holdings and he will have lost the chance of a permanent in- 
crease in dividends within the near future. 

On the other hand, let us suppose that the directors have 
raised their new capital by having the preferred stock under- 
written at or about its market price. Assuming that this new 
capital could be used as advantageously as the old capital, they 
are in position to go ahead a little later with the expected in- 
crease in dividends. 

From the standpoint of the permanent owner of the cor- 
poration's shares, there can probably be little question but 
that the steady and dependable dividend policy better serves 
his interests. It is only from the point of view of the specu- 
lative purchaser that the granting of special ''rights" and 



304 SECURING CAPITAL 

bonuses with the resulting rapid fluctuations in stock market 
prices is desirable. Sometimes, it may regretfully be admitted, 
the directors of a corporation find it to their personal ad- 
vantage to know in advance that the granting of a subscription 
privilege is anticipated. On the basis of private information, 
which is not available to all the other stockholders, they may 
buy or sell with the certainty of making individual profits. 

From the standpoint of the community there is consider- 
able sentiment against the granting of subscription privileges 
on the part of public service companies in so far as they con- 
stitute a method of stock-watering. In 1896 the Massachu- 
setts legislature passed an act referring particularly to gas and 
electric light companies, which includes the following: 

In case of an authorized increase of capital stock, 
the shares shall be offered proportionately to the share- 
holders at not less than the market value thereof at the 
time of increase. This value is to be determined by the 
Board. 

In Great Britain electric light and tramway companies may 
offer new shares to shareholders at par, even though the mar- 
ket value may be much higher. The usual practice, however, 
is to offer the new shares at only a few points under the mar- 
ket value. But there are still many cases where the share- 
holders receive substantial bonuses in the shape of "rights." 

Figuring the Value of a "Right" 

If a corporation has a million dollars par value of stock 
outstanding, with a market value of, say, $150 per share, and 
determines to issue $500,000 more of the same class of stock, 
with a subscription privilege to the present shareholders of 
buying the new stock at $125; what, under these conditions, 
is the value of the "right" to purchase one of the new shares? 

At first glance it seems obvious that the answer is $25, but 



SELLING SECURITIES DIRECT 305 

a little reflection makes it clear that this answer does not take 
into consideration the effect on the market value of all the 
shares produced by the new issue. If the corporation were 
to realize $150 from the sale of each of the new shares, and 
if the new capital were to be invested as profitably as the old 
capital, the market value of the shares would remain un- 
changed. But the company realizes only $125, and there must 
therefore be a general reduction in the market value of shares 
after the new issue has been brought out. The question, then, 
as to the value of a "right" requires some mathematical calcu- 
lations. Perhaps the best method of presenting the solution 
of our problem, is to quote the following algebraic equations 
adapted from a statement in the Wall Street Journal: 

x = rights 

y = number of rights needed to get 
one share 
Selling price = value of stock plus rights 
Selling price — x = value ex-rights 

yx + 100 = value of one share to be bought = 

value ex-rights 

yx + 100 = market price — x 

yx + x = market price — 100 

x (y + 1) = market price — 100 

market price — 100 

x = — m — 

By applying this formula to the example just cited, we 
reach the following conclusion : 

150 — 100 50 
x = — - — — = = 16.66 

2 + 1 3 

The value of this "right" is not therefore $25, as would 
have been at first supposed, but $16.66. The same result may 
be reached by the arithmetical method as follows : 

At the beginning of the operation there is in existence 



3 o6 SECURING CAPITAL 

$1,000,000 par value of outstanding stock, which at the mar- 
ket value of $150 = $1,500,000 

The $500,000 of new stock, being sold at $125, 

brings into the treasury of the corporation .... $625,000 



Aggregate value of the $1,500,000 par value of 
stock outstanding at the conclusion of the trans- 
action — $2,125,000 

Dividing 15,000 (the number of shares with a par value 
of $100 each) into $2,125,000, we have the value of each 
share as $141.66. Inasmuch as the "right" entitles the holder 
to purchase a share for $125, the value of the "right" is the 
difference between $141.66 and $125, or $16.66. 

It should be explained at this point that the term "right" 
is used on some stock exchanges to indicate the privilege of 
subscribing to one share of the new issue. On the New York 
Stock Exchange, however, the term is used as indicating the 
privilege that is granted to one share of all the stock then out- 
standing. In the hypothetical case above stated, the ''right" 
to buy one share of a new issue at the special price would be 
granted to each two shares of the formerly outstanding stock. 

Under the customary practice of the New York and many 
other stock exchanges, the "right" granted to each of the out- 
standing shares would be the "right" to subscribe to one-half 
a share of the new issue at the special price. The result of 
the above calculations should be divided by two, therefore, in 
order to give the value of the "right" under the New York 
definition of the word. The value of the "right" as defined 
in New York would be, then, $8.33. 

Making Use of a "Right" 

A stockholder who receives a valuable subscription privi- 
lege may make use of it, according to his own circumstances 
and judgment, in any one of the following ways: 



SELLING SECURITIES DIRECT 



307 



i. He may actually purchase his share of the new issue 
at the special price, thus making an especially ad- 
vantageous investment. 

2. In case he does not have capital at hand for this pur- 

pose, he may decide to sell his "right" in the open 
market to some one else who would like to buy the 
stock or to speculate in the value of these "rights." 

3. He may sell "short" — that is, without making de- 

livery — an amount of stock equal to that which he 
may obtain at the special price under his subscrip- 
tion privilege ; in this case he will later take up the 
stock to which he is entitled and with this stock 
make his delivery. 

The first method is desirable if the stockholder happens to 
be in a position to buy of this particular stock at the time the 
privilege takes effect. As most people keep their money in- 
vested very closely, it is probable that most stockholders do not 
make use of their privilege in this manner. 

The second method is the simplest, and probably the one 
that is most used. For this very reason it usually involves 
more or less sacrifice. Very seldom has it happened that the 
market quotations for a "right" equal the theoretical value of 
the "right" as above calculated. There is likely to be a strong 
pressure to make sales on the part of numerous stockholders, 
with a limited demand, which naturally makes a price that is 
favorable to the purchaser rather than to the seller. For this 
reason many stockholders of considerable means prefer the 
third method. By selling "short" they take advantage of the 
optimistic feeling which is likely to maintain the price of the 
stock nearly up to its former level during the period imme- 
diately after the subscription privilege is announced, though 
the theoretical value of the stock may have considerably de- 
creased. The stockholder who sells "short" under these con- 



308 SECURING CAPITAL 

ditions is taking very little risk inasmuch as he is certain to 
be able to make delivery when the subscription privilege takes 
effect and is usually able to sell under the most favorable con- 
ditions. 

Whether the shareholder exercises his "right," sells it to 
some one else, or sells "short" and then delivers his new stock, 
is presumably a matter of indifference to the corporation. In 
any one of these cases, the stockholder is clearing a profit and 
the capital which the corporation desires to secure has been 
obtained. 

A question which often arises is whether a corporation 
needs the support in such a transaction of an underwriting 
syndicate. This question will be touched upon later (Chap- 
ter XV). 

Selling at Auction 

We may next take up the case of a corporation which 
desires to raise a considerable amount of new capital either 
at its organization or at some later stage in its development, 
and which cannot count on meeting its needs by selling to its 
own stockholders or to those intimately associated with the 
business as employees or customers. The corporation, we will 
assume for the present, either cannot command or does not 
desire to obtain the services of bankers or stock exchange 
brokers, but wishes to deal directly with the prospective 
purchasers of its securities. In other words, the corporation 
is in the position of wishing to sell its own securities to the 
public at large without the employment of intermediaries. 

The simplest method, and one which is much used among 
public utilities abroad, although almost unknown in this coun- 
try, is known as the "auction" or "tender" method. The cor- 
poration either disposes of its securities at public auction, or 
by public advertisement invites tenders and sells to the highest 
bidders. 



SELLING SECURITIES DIRECT 



309 



This method is required by statute in England of all gas 
and water companies. It is believed to have originated with 
the Nottingham Gas Company in 1845, and is now generally 
agreed to be the most economical method of floating new is- 
sues, either of share capital or of loan capital, for companies 
of this class. The so-called "Model Auction Clause" provides 
among other things : 

1. That due notice of the intended sale be given at least 

28 days before the date of the auction. 

2. That a reserved price be fixed and sent in a sealed 

letter to the Board of Trade. 

3. That no block of shares offered for sale be of more 

than £100 nominal value. 

4. That the total sum payable by the purchaser be due 

within the three months from the date of the auction 
or the acceptance of the tender. 

5. That any shares not taken at the reserved price may 

then be offered to previous shareholders and em- 
ployees and to consumers. 

6. That any shares still remaining unsold shall be again 

offered for sale and, if unsold after the second at- 
tempt, may be disposed of at such price and in such 
manner as the directors may determine. 

The well-known firm of A. & W. Richards of London 
handles practically all of the auction sales of gas securities, 
and sales usually take place at the offices of this firm on Tues- 
day of each week. 

The auction or tender method eliminates the immediate 
cause of speculative fluctuation, inasmuch as it does away with 
"melon-cutting." There has been little difficulty in obtaining 
plenty of bona fide bids from permanent investors. Brokers 
and bankers find that they cannot purchase at a price which 
will permit them to resell at a profit. There seems to be no 



3JO 



SECURING CAPITAL 



question but that the policy is working well with gas and water 
companies ; yet for some reason it is not applied to other public 
utility corporations. 

In Canada, the Consumers Gas Company of Toronto fol- 
lows the same practice. During the last several years, it has 
sold 59,508 shares of a par value of $50 each at public auction, 
the prices averaging about $200 per share. In this country 
the plan has been adopted only in the city of Boston, where 
it is provided that the new shares of gas and electric light 
companies shall be sold at public auction. 

In view of the long continued and successful experience 
of the English gas and water companies in raising capital 
by this method, it would appear that the advisability of its 
further application to public utility companies in the United 
States — and possibly even to other companies' securities 
which appeal to the investing public — would be well worth 
careful consideration.* 

Finding Prospective Buyers 

At the best, however, the auction and tender method above 
described is not applicable to the great majority of corpora- 
tions which are not sufficiently well known or well established 
to secure offers to buy their shares and bonds by the simple 
process of stating that given securities are for sale. They 
must go out looking for prospective buyers and must carry 
on an active campaign for the purpose of disposing of their 
securities. To determine the amount and nature of the securi- 
ties to be offered belongs to the field of financing proper; what 
methods should be adopted in disposing of these securities 
directly to investors is primarily a selling problem. This prob- 
lem as applied to the sale of securities can be analyzed as 
follows : 



*See report on "Regulation of Public Service Companies in Great Britain," 
prepared by Robert H. Whitten, Librarian-Statistician, Public Service Commission, 
State of New York, First District, Published by the Commission, New York City, 1914. 



SELLING SECURITIES DIRECT 



311 



1. How to obtain the names of prospective buyers. 

2. How to approach these prospective buyers in a suit- 

able and attractive manner. 

3. How to arouse their interest. 

4. How to secure their confidence. 

5. How to create a desire on their part to purchase the 

securities that are being sold. 

6. How to secure a favorable decision and consummate 

the sale. 

It is necessary here only to present a few remarks as to the 
application of the principles of salesmanship to this problem 
of disposing of securities. 

The first method of securing the names of prospective 
buyers, which occurs to many organizers or managers of small 
corporations, is advertising or extensive circularizing. This 
method, however, has proved itself almost worthless for sound, 
legitimate enterprises, although it is extensively used by un- 
sound enterprises. First of all, the very fact that swindling 
promoters of alleged oil companies, mining companies, and the 
like have used this method so largely is almost a decisive 
argument against it. It has become — perhaps unfortunately — 
so closely associated with fraud that any offer of stocks or 
bonds that is made through advertising and circularizing is at 
once looked upon with suspicion by most conservative men. 
A more fundamental objection is that the method is bound to be 
expensive. It is not likely that any securities, unless they 
should be the securities of companies already widely and favor- 
ably known, could be sold by advertising and circularizing at 
an expense of less than 25 to 40^ of their offered price, which 
is entirely too high for a legitimate enterprise. The selling 
expense ought not to exceed 5 to 10%. 

The plan may be modified to the extent of circularizing only 
selected lists made up, for example, of the customers or prob- 



312 



SECURING CAPITAL 



able customers of the enterprise. If the list is carefully 
selected, and the circularizing carried on in a dignified and 
effective manner, this method may sometimes prove inex- 
pensive and successful. The remarks in a preceding section as 
to the advisability of securing capital from customers and 
employees support this view. It must be borne in mind, how- 
ever, that there is grave danger here of arousing the suspicion 
that the corporation is financially embarrassed or at any rate 
is not sufficiently well financed to provide funds for proper 
development. 

The third and ordinarily the best method of finding pro- 
spective buyers for securities of small corporations is through 
personal inquiries. It may seem at first glance that this state- 
ment is in contradiction to the customary practice in marketing 
commodities. "Experience has long ago proved," it may be 
argued, "that making personal inquiries is a slow and highly 
expensive method of locating prospective buyers for auto- 
mobiles, for real estate, and for many other high-priced com- 
modities. At any rate it should be supplemented and supported 
by advertising, circularizing, and other cheaper methods. Why 
should not the same principle apply to the sale of blocks of 
securities?" 

The answer to this natural inquiry is that the element of 
confidence in the management of an enterprise is a vastly more 
important factor in effecting the sale of stocks and bonds than 
it is in effecting the sale of a tangible commodity. The pur- 
chaser of a security does not terminate the transaction when 
he pays over his money and receives his certificate or his bond. 
He is just beginning at this point his relations with the cor- 
poration and its management. If he is wary, therefore — and 
the majority of people with capital to invest are wary — he will 
not part with his capital until he feels well assured of the 
honesty and competence of the management of the enterprise. 
When the corporation is well-established and well-known, or 



SELLING SECURITIES DIRECT 



313 



when the offer comes to him through a banking house of high 
standing, or when he is personally acquainted with the man- 
agers, the necessary feeling of confidence is quickly established. 
If none of these favoring conditions exist, however, the best 
substitute is to approach the prospective buyer with a personal 
introduction or recommendation which tends to establish con- 
fidence. 

Here we have the basic reason for the unquestionable fact 
that only through the personal influence and activities of the 
responsible officers or of trusted representatives can the securi- 
ties of a small corporation be successfully sold to the general 
public. For this reason the expense of finding prospective pur- 
chasers through such impersonal methods as advertising or 
circularizing is in almost every case prohibitive. 

The organizer or manager of a small corporation which 
needs capital may as well make up his mind at once that he is 
the man who should find the capital and that he should work 
through his acquaintances and through the respected business 
men of his community or of his line of business. He may be 
greatly surprised, frequently, to find how quickly and easily 
he can locate capital, the existence of which he had not pre- 
viously suspected. 

The Prospectus 

For the same reason that the seller of most commodities 
needs either a sample or a catalogue, the seller of securities 
needs a prospectus. Its essential characteristic is that it is a 
written statement of the record, the present condition, and 
the prospects of the corporation and of the terms on which its 
securities are offered for sale. No prospective purchaser of 
securities, who is not one of the inside managers of the concern, 
will be likely to buy until after a written statement has been 
put into his hands and he has had an opportunity to look it 
over. Even though his analysis of the statement may not be 



314 SECURING CAPITAL 

thorough, still the fact that it is made in writing tends to in- 
crease his confidence. Verbal assurances which he discounts 
acquire greater strength when they are committed to perma- 
nent written form. The written statement may take the form 
of a private letter ; it may be a somewhat more formal type- 
written statement; or, if intended for wider distribution, it 
may be printed. The form in which the statement is given 
does not change its essential character : it contains the definite 
representations on the strength of which the security is being 
sold, and for this reason is of importance both in effecting the 
sale and in connection with any legal questions that may later 
arise. 

If the corporation which is selling the securities is well- 
established and has been running for some years, the most 
important statements in the prospectus are the records of earn- 
ings and the balance sheets. These figures should be scruti- 
nized and analyzed with the greatest care. Attention should 
be given to omissions as well as to allegations of fact. The 
record of earnings, for example, should go back, not one or 
two years, but possibly five or six years. The list of assets in 
the balance sheet should be checked with a suspicious eye, and 
it should be noted whether ample reserves for depreciation and 
loss have been established. Sometimes it is claimed that it 
would be inadvisable to present records of earnings over a 
period of years, on the ground that this would be making public 
information that might be of value to competitors. If the 
business is of so secret a character that even its records of 
profits are not to be made known to its stockholders or pro- 
spective stockholders, it is certainly not the kind of a business 
which should offer securities to the public at large. 

A common practice in writing prospectuses, which properly 
arouses suspicion, is the presentation of vague and plausible 
statements that do not commit the corporation or its promoter 
to anything definite, and yet are intended to create the im- 



SELLING SECURITIES DIRECT 



315 



pression that remarkable profits are in prospect. In the pro- 
spectus of a small copper mining company, for example, it is 
stated that "copper mining has proved a source of some of the 
greatest fortunes the world has ever known, and its possibilities 
are not yet exhausted." This statement is literally true, and 
in its proper context is certainly not objectionable. But when 
it appears in a prospectus, with the obvious intention of sug- 
gesting that the particular company which is offering its stock 
is likely to prove a boundless source of wealth, it may well 
cause suspicion as to the entire sincerity and good faith of the 
authors of the prospectus. Because of the fact that glowing 
statements beget suspicion rather than confidence, the writers 
of prospectuses for high-grade companies frequently go to 
the other extreme and decline to commit themselves in any 
way as to the future. They will not even express an opinion. 
By so doing they may avoid straining anyone's confidence in 
their statements, but they lose the persuasive power of their 
own well-founded belief in the future growth of the enterprise. 
The skilled prospectus writer will steer his way carefully be- 
tween these extremes. 

An important factor in creating confidence, especially in a 
new corporation, is the list of names of men who are identified 
with the management or have consented to join the board of 
directors. Knowing this to be true, many unscrupulous 
promoters have deliberately set to work to secure "ornamental" 
directors who, for some consideration or because of personal 
vanity, are willing to become members of the new board. 

Probably this practice has prevailed to a greater extent in 
the organization of banks than in any other line of business. It 
is unquestionably a vicious practice and the careful purchaser of 
securities is likely to be repelled rather than attracted when 
he sees a number of widely advertised names included in the 
directorate. 

It is always desirable that the prospectus should be dignified 



3i6 



SECURING CAPITAL 



in its form and in its contents. Red ink and buffoonery may 
conceivably help to sell some commodities, but they will not 
help to sell thousands of dollars of stock and bonds. A man 
who is thinking of putting his money into securities, generally 
looks upon the proposition seriously and does not ask to be 
either startled or amused. 

However, this need not prevent a strong appeal at times 
to other motives besides money-making. A trust company in 
a small Texas city, for example, which had been unable to raise 
additional capital that it badly needed, found that it had no 
difficulty in getting capital as soon as it put its appeal on the 
ground of the local pride which should be felt by the leading 
ranchers and merchants of the community in building up a 
sound financial institution. The sentimental appeal, if it is 
used, must of course be sincere and legitimate. Otherwise, 
it becomes mere bathos and a destroyer of confidence. 

It is a well-established legal principle that misrepresenta- 
tions or fraud in the prospectus may invalidate a subscription 
to the stock which the prospectus is designed to sell. It is, 
however, extremely difficult to prove either misrepresentation 
or fraud. In 99 cases out of 100 they are merely to be sus- 
pected. Very seldom does the prospectus writer find it neces- 
sary to make statements that are directly false. He insinuates 
an untruth, but he avoids saying it. Even the most extrava- 
gant accounts of the prospectuses of swindling companies rarely 
contain false statements of fact. Whatever is said as to the 
future is merely expressed as an opinion. 

Limitations of Direct Sale 

One advantage of selling securities direct rather than 
through bankers and brokers is the belief commonly held by the 
purchasers that in this way they avoid contributing anything 
to the expense of making the sale. They argue to themselves 
that, if a brokerage firm were to dispose of a block of securities, 



SELLING SECURITIES DIRECT 317 

it would require a commission of, say, 5 to 10% or more, 
whereas when the corporation itself, through its officers or 
direct representatives, disposes of its securities, no commission 
need be paid. It is, of course, obvious that there is a fallacy 
here, inasmuch as the effort and expense on the part of the 
corporation in conducting the sale is just as truly selling cost 
as would be a commission paid to bankers or brokers. As a 
matter of fact, the moment direct selling of its own securities 
by a corporation gets beyond a certain limited field, it becomes 
impracticable on account of its high cost. We have already 
seen that advertising and circularizing will not produce the 
right kind of inquiries for legitimate propositions except at 
excessive cost. Personal work on the part of officers or pro- 
moters of a corporation, who inquire among their friends and 
proceed from one man to another until they reach people with 
money to invest, is also slow and expensive. The idea is not 
impracticable when the amount of capital to be raised is com- 
paratively small; but as the amount of capital increases, the 
difficulty and expense of this method become progressively 
greater. 

It is, of course, impossible to say definitely how much 
capital can properly be raised in this manner. That will depend 
in part on the personal resources and acquaintanceships of the 
officers. Some years ago the Continental Rubber Company, 
which operates in the Congo, was organized as a close cor- 
poration by a small group of wealthy New York capitalists. It 
had a capital stock of $10,000,000, all of which was readily 
secured by personal solicitation. On the other hand, an in- 
ventor who is not in touch with business men may find it a 
matter of great difficulty to raise a few hundred dollars. We 
can perhaps form some approximate standard by considering 
the fact that banking and brokerage houses rarely care to 
consider undertaking the sale of securities of corporations 
which are not capitalized at $1,000,000 or more; also, they 



318 SECURING CAPITAL 

do not care to sell any block of securities amounting to less 
than $200,000 to $500,000 at the lowest. Blocks of securities 
of smaller amounts, therefore, cannot be sold ordinarily in any 
other manner than through the personal efforts of the pro- 
moters or managers of the corporation. Blocks of securities 
of larger amounts can generally, but not always, be sold more 
cheaply through banking and brokerage houses than through 
direct personal efforts. 

That there are some exceptions to this last statement will 
at once be granted. For example, a large coal and lumber 
company has recently undertaken to sell $15,000,000 6% gold 
bonds and has sent out a number of high-grade salesmen who 
are being paid a 10% commission. The success of this attempt 
is not yet assured. The company has the advantage of having 
well-known business men at the head and of having large lists 
of dealers to whom they may go with an especially telling offer. 

This general question of the relative expense of various 
methods of selling securities may be better considered after 
we have reviewed the methods of selling through dealers and 
through stock exchanges, as discussed in the following chapter. 



CHAPTER XIV 

SELLING SECURITIES THROUGH DEALERS 

Classes of Security Merchants 

The general classes of security dealers correspond to the 
classes of dealers in merchandise, as follows: 

i . Wholesalers 

2. General retailers 

3. Retail specialists 

It will quickly appear that these three classes are not 
clearly defined ; nevertheless it is usually possible to classify a 
given banking or brokerage house as belonging to one of 
these groups. The wholesale dealers are interested only in the 
largest issues and make little effort to sell in small lots direct 
to individuals. In the United States, J. P. Morgan and Com- 
pany, Kuhn, Loeb and Company, Speyer and Company, and 
a number of other firms not quite so well-known constitute 
this group. When a house of this type undertakes to sell 
a large issue, it usually proceeds to form an underwriting 
syndicate composed of firms which belong wholly or partly 
in the second group and which are equipped to sell the securi- 
ties direct to the purchasing public. 

The second group includes such houses as Spencer Trask 
and Company ; Harris, Forbes and Company ; White, Weld and 
Company, which maintain large organizations of bond and 
security salesmen and keep comprehensive and valuable lists 
of people who are known to have money available for invest- 
ment. Such houses, when they are members of underwriting 
syndicates, are prepared to assume a large share of the burden 

319 



320 



SECURING CAPITAL 



of actually disposing of the securities offered. They may 
also take up smaller issues of securities wholly on their own 
account without forming an underwriting syndicate and may 
dispose of these issues to the public. There is no sharp line 
between houses in this group and houses in the first group. 

The third group, consisting of specialists in the different 
classes of securities, is more clearly defined. It is distin- 
guished from the second group by the fact that the list of 
prospective buyers in a specialty house is made up exclusively 
of people who have shown an interest in the specialty and 
is not merely a general list of people who have money to 
invest. The difference is much the same as between a depart- 
ment store and a retail shop which specializes in one line of 
goods. These specialty houses again differ from the stock 
exchange brokerage firms which are described a little later in 
this chapter. It would be impossible to list all of the 
specialty houses. One deals exclusively in oil stocks; another 
in the securities of the powder companies; another in equip- 
ment bonds and car trusts ; another in the first mortgage bonds 
of public utilities; another in bank, trust company, and 
insurance company securities. 

We may also include in this third group a large number 
of small banking and brokerage houses scattered over the 
country which specialize in local securities. Every city of any 
size has a considerable number of successful corporations 
the securities of which are from time to time bought and 
sold. These local firms handle business of this type. Usually 
they are also the correspondents and representatives of New 
York houses and are in position to help sell the big security 
issues in which New York is interested. 

Handling an Issue 

A brokerage house in good standing which undertakes to 
sell a bond or a stock issue will first of all wish to inform 



SELLING SECURITIES THROUGH DEALERS 321 

itself fully and accurately as to the soundness of the issue. 
It will carry on a preliminary investigation along the same 
lines that have been fully described in Chapter X, "Promo- 
tion." In case the preliminary investigation is satisfactory 
and the terms are agreed upon, the house will then, prob- 
ably through its own engineers and accountants, delve still 
deeper into the records of the corporation and satisfy itself 
beyond a doubt of the conservatism of all statements upon 
which the sale of the security is to be based. Then it will 
proceed to dispose of the securities. Sometimes an advertise- 
ment of the security will be approved, and there may be 
some circularizing with a dignified prospectus. Generally 
speaking, the real object of this advertising and circularizing 
is probably not so much to dispose of the issue immediately 
in hand, as to build up the firm's list of prospective buyers 
of securities. 

It is this list of prospective buyers which is the firm's 
chief asset. Having this list, it is not necessary that it should 
continually incur the great expense above referred to of 
securing the names of prospective buyers through advertis- 
ing and circularizing ; that is, this expense is spread over the 
cost of selling many different issues instead of being charge- 
able wholly to one issue. 

It is clear that so far as investigation is concerned the 
expense is almost as great for a small issue as for a large 
issue. Furthermore, the large issue can generally be sold in 
larger blocks than can the small issue. It is likely to be the 
issue of a better known corporation and is more easily sold. 
All three of these reasons operate to make the brokerage 
house anxious to secure the privilege of selling large issues 
at small commissions, and reluctant to undertake the disposal 
of small issues even at high commissions. 

When the great joint loan of the English and French 
governments amounting to $500,000,000 was placed in this 



322 



SECURING CAPITAL 



country in the fall of 191 5, the bankers accepted for them- 
selves a commission of Ij4%. This is the greatest sale of 
securities and the smallest commission on record in this 
country. When the National City Bank of New York in 
the latter part of 19 14 undertook to sell $15,000,000 of the 
notes of the Argentine government in this country, the com- 
mission was 3%%. The large bond issues of great railroad 
corporations are ordinarily sold on a commission of 3 to 5%. 
The smaller bond issues and the first-class preferred stock 
issues of industrial concerns are sold at commissions of 5 
to 10%. Sometimes commissions go higher, but that is not 
usual for the reason that the better established houses do 
not care to identify themselves with any security which re- 
quires more than a 10% commission to cover all selling 
expenses and still leave a satisfactory profit. It is, of course, 
true that even higher commissions and special bonuses payable 
in stock of the issuing corporation are not unknown. 

When a brokerage house is handling a small issue and 
finds it difficult to make cash sales, it may frequently resort 
to "swapping" for other better known securities that are 
owned by its clients. In this way the brokerage house may 
obtain bonds or stocks which it can actually sell for cash. 
The process, however, is more or less risky and expensive 
and amply justifies a high commission. 

Obligation of the Brokerage House 

A question that is bound to arise whenever a bond or 
brokerage house recommends a security which afterward 
turns out to be a poor purchase, concerns the extent of the 
obligation which the house should be willing to assume. So 
far as the legal obligation goes, the house is always careful 
to protect itself by disclaiming responsibility for the state- 
ments of fact which it transmits from the corporation to the 
purchaser and by clearly setting forth that prophecies as to 



SELLING SECURITIES THROUGH DEALERS 323 

the future represent only its opinions and not definite 
promises. This attitude is in itself entirely correct; yet there 
remains a certain moral obligation which the better houses 
are quite willing to recognize. As to how far this obliga- 
tion extends, there is naturally considerable difference of 
opinion. 

Clearly there is rarely a well-marked opposition of interest 
in this matter between a well-established banking house of 
high repute and its customers. The prosperity — the very 
existence — of the house is dependent upon its ability to retain 
the unquestioning confidence of a large number of investors. 
Every time a security which it handles goes wrong, that con- 
fidence is perceptibly diminished. The reputable banking 
house, therefore, takes great pains in the first place to make 
certain that its statements of fact are fully verified and that its 
recommendations are justified. As a further protection, it 
is customary for the banking house to obtain for itself some 
kind of representation, direct or indirect, on the board of 
directors of the corporation. It is thus in position to keep it- 
self informed and to exercise some influence on the future 
policies of the enterprise. If, in spite of these precautions, 
the corporation's record is unsatisfactory and the market 
value of its securities decline, the banking house will fre- 
quently try to maintain the market price and perhaps will 
quietly assist its clients in disposing of their holdings. If 
the market decline seems to be due to extraneous factors 
rather than to any real falling off in the financial standing 
or profits of the corporation, the banking house will perhaps 
be satisfied with doing what it can to maintain the price 
and with reassuring its own clients. In case the situation be- 
comes worse and the corporation finally goes through 
insolvency and reorganization, the banking house will in all 
probability do its best to secure favorable terms for the 
holders of the securities which it has itself recommended. It 



324 SECURING CAPITAL 

has even sometimes happened that the security merchant will 
repurchase securities which he has sold and which have after- 
ward declined in value, at their original selling prices; but 
this is an exceptional case and is not to be expected as a regular 
policy. ■ 

On the whole, as the investing public comes to be better 
educated in financial affairs, and as the standards of correct 
practice in these matters become better established, there is 
evidently a strong tendency toward more complete and un- 
questioning recognition on the part of the security merchant 
of his moral obligation. The case is rare where the pur- 
chaser from a reputable house has any just cause for vigorous 
complaint. 

Limitation of Sale Through Security Merchants 

It was pointed out in the preceding chapter that issues be- 
low $200,000 to $500,000 are too small to bear the expense 
of thorough investigation on the part of security dealers and 
must, therefore, ordinarily be sold direct by the corporation 
or its promoters. This establishes in a general way a lower 
limit of the security merchant's activities. On the other hand, 
very large issues of bonds or shares which soon after their 
issue will enjoy an active market on an important stock 
exchange, are frequently best handled with the assistance of 
stock exchange operations. This does not mean, as will be 
explained a little further on in this chapter, that the large 
banking houses do not underwrite and dispose of these securi- 
ties. It means only that they use a slightly different method. 
Speaking in general terms, it is usually true that issues of 
say $10,000,000 to $20,000,000 and over, are at once listed 
on the New York Stock Exchange, and the efforts of the 
houses which handle the issue are directed toward encourag- 
ing purchases through the exchange as well as toward making 
sales direct to their own customers. This is a method that 



SELLING SECURITIES THROUGH DEALERS 



325 



differs slightly from the one that has been described. The 
figures just stated give in a general way the upper limit of 
security issues that are handled exclusively through the method 
of direct sale by security dealers to customers. 

Besides paying the bankers' commission, the issuing 
corporation must frequently pay heavy legal expenses as well 
as fees to accountants, intermediary brokers, and others, 
which run to a high figure. Inasmuch as arrangements of 
this kind are of a confidential nature, they are not officially 
recorded and for this reason it is difficult to give exact 
figures. 

Following is a statement showing the expenses incurred 
by A. L. Barbour in 1896, in carrying through the sale in 
London of £400,000 6% debenture bonds of the New 
Trinidad Lake Asphalt Company : 

Underwriting commission, 10% £40,000 

Fee to City of London Contract Corporation, 

Limited, and to Henry Bell, Esq 15,000 

Expenses of the City of London Contract Cor- 
poration, Limited J, 022 

Fees to Seward, Guthrie and Steele, Attorneys 

in New York 2,183 

Fees to Ashurst, Morris and Crisp, Attorneys 

in London 1,500 

. Fees to accountants and brokers and miscel- 
laneous expense 10 293 

£69,998 

This is a selling expense of 17^2%. It is, to be sure, 
exceptionally high, but it must be admitted that it has often 
subsequently been equalled.* 

A further limitation is to be found in the fact that the 
decisions of security merchants as to taking on new issues 

•Figures taken from Dewing's "Corporate Promotions and Reorganization," p. 419. 



326 SECURING CAPITAL 

are frequently determined as much by their own position as by 
the intrinsic strength and salability of the propositions. If a 
banking house has already entered into arrangements to sell 
certain issues of a given type, it will not be in position to 
take on new issues of the same type. For its own safety, 
it would prefer to offer to its customers a diversified list. 
It has sometimes happened, for this reason, that a really 
excellent proposition has been refused by all the houses which 
would otherwise have been glad to take it up. 

Requirements of the Security Merchant 

As a partial illustration of some of the principles which 
have been set forth above, it will be of interest to review an 
actual proposition recently presented to a number of banking 
and brokerage houses, and to summarize the reasons which 
influenced all of them to decline to take up the proposition. 

Over sixty years ago two brothers established a flour mill 
in the State of Missouri. The enterprise was successful and 
the brothers, being men of exceptional ability, took over 
from time to time other enterprises. In the course of years 
they became very wealthy. It was agreed between them that 
after their deaths the properties which they then owned 
should be vested in a trust and held intact over a period of 
years for the benefit of their heirs, and this arrangement 
was carried out. One brother died about twelve years ago 
and the other about ten years ago. At the time when the 
proposition was formulated for presentation to banking 
houses, the period of trusteeship was about to end and, unless 
some other plan were worked out, the estate was to be 
appraised and distributed among the heirs. 

The property held in trust comprised 3,000 acres of land, 
a flour mill, an ice plant, an electric light and power plant, 
and a manufacturing establishment. The power for the 
industrial enterprises was furnished by the electric light and 



SELLING SECURITIES THROUGH DEALERS 327 

power plant, and they were also located so that they could 
best be operated under a single administrative management. 

To break up the estate was certain to involve considerable 
loss in values. Seeing this situation, a young business man 
of ability and good standing in the community secured from 
the heirs an option to purchase the whole estate for 
$1,500,000. A record of earnings during the preceding five 
years showed an average of approximately $120,000. It was 
stated, however, that the estate had been loosely managed 
and that by the use of modern business methods it could be 
made to yield an annual profit of at least $300,000. It 
was estimated that about $500,000 cash would be needed in 
order to modernize the plants and to provide ample working 
capital. The promoter wished, if possible, to bring out a 
bond issue of $1,500,000 and was himself prepared to raise 
the additional $500,000 required by the sale of common stock. 

After presentation of this proposition to a number of 
bond houses, the following summary of their objections was 
drawn up: 

1. The earnings for the past five years are neither 
sufficiently large to be attractive to a clientele of small 
investors, nor to guarantee unbroken interest payments 
on the bonded indebtedness proposed. In other words, 
if your outstanding bond issue is guaranteed to yield 6%, 
on the showing made by the property for the last five 
years, you have too narrow a margin. The property 
should be made to yield earnings at least twice the amount 
of the fixed charges before the proposition would be in 
shape. 

2. The cost to investigate the reliability of the entire 
property in all its phases would surely be heavy, and 
might be disproportionate if unexpected obstacles were 
encountered. 

3. The property has for about sixty years been a 
family affair. You have probably already met with hesi- 
tancy on the part of bankers to have any financial rela- 



328 SECURING CAPITAL 

tions with matters involving families. While this attitude 
is, of course, not always justifiable, it is unquestionably- 
true that the guiding of a proposition through the intri- 
cacies of family relations is oftentimes extremely 
difficult. 

4. The fact that it is proposed to put a blanket bond 
issue on several widely different types of assets adversely 
affects the proposition. While the bond issue is to cover 
one property, it is easy to conceive of the trouble which 
might arise from the administration of several highly 
different types of organization under one management. 
Not only might this mean inefficiency in handling these 
properties, but it would be almost impossible for the bond- 
holders to determine whether each property was yielding 
a reasonable return or whether it was eating into the 
profits earned by the other companies. 

5. Finally, in the opinion of the bankers, the whole 
matter is as yet in an embryonic state. It is now a capi- 
talist's, not an underwriter's, opportunity. The proper 
plan would be to raise at least $1,000,000 by the sale of 
stock and to pay the owners of the estate by giving them 
$500,000 in cash plus a five-year secured note for 
$1,000,000, with the understanding that within the fixed 
period mortgage bonds would be sold and the note of 
the estate would be paid off. If this were done, the 
bonds could now be authorized, but would remain un- 
issued for, say, two or three years Or until such a time 
as the company becomes a smoothly-running, well-oiled 
mechanism showing a return of 15 or 20% on its 
valuation. Then, if the bonds were offered, we believe 
it would be a comparatively easy matter to float the 
issue. 

The plan above outlined did not prove acceptable and the 
whole project has since been dropped. 

Stock Exchange Methods 

Earlier in this chapter it was remarked that when security 
issues of great size are to be floated, it is generally advis- 



SELLING SECURITIES THROUGH DEALERS 



329 



able to have them at once listed on the stock exchange and 
to effect at least a portion of the sales through stock ex- 
change transactions. One advantage is that the ready market- 
ability of the security is at once established, thus making it 
easier to sell it at a high price. Another even more direct 
advantage is the fact that considerable quantities may be pur- 
chased through the exchange by people who are not listed as 
customers of any of the bond houses which float the issue, 
or who prefer to buy and sell through the exchange rather 
than "over the counter." 

Inasmuch as a full description of stock exchange methods 
and of the factors which affect stock exchange quotations 
would require more space than is here available, it is not 
feasible to do more than to give a brief review of the main 
facts. 

Fundamentally an exchange is simply a meeting place for 
people who wish to buy and sell securities. In the eighteenth 
century the London coffee houses grew to be the natural 
centers for business dealings, and gradually the custom arose 
of buying and selling through agents, who made it a point 
to meet for this purpose. It was a natural step forward to 
form an organization of these agents or brokers and to 
establish definite hours and fixed rules to govern the trading, 
and when that step was taken the stock exchange came into 
existence. Much the same series of stages has marked the 
evolution of exchanges in all the other principal commercial 
cities of the world. There are important exchanges today 
not only in London, New York, Paris, and Berlin, but in 
Antwerp, Rotterdam, Vienna, Petrograd, Buenos Aires, Rio 
de Janeiro, Valparaiso, and numerous other cities. Within 
the United States the chief exchanges outside of New York, 
are in Boston, Philadelphia, Baltimore, Cleveland, Cincinnati, 
Chicago, New Orleans, and San Francisco. This is by no 
means a complete list. Even some of the smaller cities, such 



330 



SECURING CAPITAL 



as Rochester, New York, have stock exchanges of some 
importance. 

All the exchanges are organized on the same general plan. 
They are non-stock corporations, similar in their essential 
constitution to clubs. Members are admitted on payment of 
dues, provided a membership or "seat" has been purchased 
from some member who wishes to retire. The mere fact 
that membership has been purchased, however, is not suffi- 
cient in itself to guarantee admission. The membership com- 
mittee may, for any reason that it sees fit, decline to accept 
the applicant. 

Seats on the leading stock exchanges frequently sell at 
very high figures. Their value is apt to fluctuate a great 
deal from time to time, depending upon the amount and profit- 
ableness of the business which is being handled by the ex- 
change. A price of $70,000 to $80,000 for a seat on the 
New York Stock Exchange is not uncommon, though within 
recent years as little as $30,000 has been paid. 

The brokers who hold membership on an exchange are 
required to charge standard commissions for buying and sell- 
ing. On the New York Stock Exchange the brokerage on 
each transfer of a security is Y%% of the par value, or $1.25 
per thousand dollars; thus the normal difference between the 
buying price and the selling price of a stock exchange security 
is J4%. On the London Exchange, brokers' commissions are 
determined by individual firms and have not been so 
definitely standardized. The buying and selling of securities 
often reach an enormous volume ; for instance, million-share 
days on the New York Stock Exchange are by no means 
uncommon. Naturally, much of the buying and selling is 
at once offset by a corresponding resale or repurchase. A 
certain portion of the brokers are known as "scalpers" and 
make it their sole business to take advantage of quick fluctua- 
tions in prices. A broker of this type may buy 1,000 shares 



SELLING SECURITIES THROUGH DEALERS 



33 1 



with the full intention of reselling within a few minutes or, 
at any rate, before the close of the day. He is satisfied 
if he makes a profit of */$ to % on the transaction. 

Other members of the Stock Exchange seldom or never 
appear on the floor, but operate entirely through their fellow 
brokers. The advantage to them of membership lies in the 
fact that the regular commission on transactions for fellow 
brokers is reduced to the very low figure of $2 per hundred 
shares. By far the great majority of the brokers do little or 
no buying and selling on their own account, but are satisfied 
with handling the orders given them by their customers. 

On the London Stock Exchange there are two classes of 
traders, known as "jobbers" and "brokers." The broker deals 
with outside customers and turns over the actual filling of the 
order to the jobber. On the New York Stock Exchange 
the transactions of every day are "cleared" at the end of the 
day. That is to say, purchases and sales of the same security 
are checked off against each other so that there need not take 
place the vast amount of handing certificates from hand to 
hand which would take place if every sale were to be accom- 
panied by an actual delivery. After purchases and sales 
have been checked, there remains only a comparatively small 
residue of actual deliveries required in order to close the day's 
transactions. On the London Stock Exchange the period 
of settlement comes only once a fortnight. Three days are 
allowed for checking up and turning in records of purchases 
and sales, for giving to brokers the names of the people 
to whom their certificates are to be transferred, and for 
making payment and accepting delivery. This complex 
machinery is required partly because of the English practice 
of registering the names of all holders of securities. Securi- 
ties to bearer or securities under the American plan of 
requiring only indorsements in blank, can be much more 
easily handled. 



332 SECURING CAPITAL 

Importance of Speculative Dealings 

It is doubtless well known to the readers of this volume 
that the great mass of transactions on most of the exchanges 
have a speculative character. A great many securities, to be 
sure, are actually taken out of safe deposit boxes and brought 
into the market to be sold outright, and a great many securi- 
ties are every day purchased to be held as permanent invest- 
ments; yet the speculative buying and selling overshadows 
investment buying and selling. 

The activities of the "floor traders" or "scalpers" who buy 
and sell for a profit of % to *4 % have been mentioned. Many 
of these traders, though not all, make it a point to match 
all their purchases and sales before the end of every busi- 
ness day, thus reducing their risk of heavy loss to a minimum. 
These men proceed almost as much by intuition as by rea- 
soning. If they see in the manner of bidding of other 
brokers, or "feel it in the air," that a given security is tend- 
ing upward, they will help along the movement by making 
a purchase with the expectation of reselling a little later at 
a slight profit. One result of their activities is to concentrate 
attention and the volume of transactions on a few active 
securities. Their business thrives on rapidity of fluctuation in 
prices. However, their operations tend to restrict the range of 
fluctuation for they are ready to buy on a momentary drop in 
price or to sell on a momentary rise, and to resell or rebuy as 
soon as the normal level is again reached. 

A second group of speculators consists of brokers and of 
others who are in close relation with the Wall Street market 
and who carry on buying and selling campaigns with the 
expectation of "cashing in" within a few weeks or months. 
Sometimes a group of these operators will form a syndicate 
for the purpose of "bulling" or "bearing" the price of a 
security. Through "matched" orders for buying and selling 
they create an artificial activity, and bring about great changes 



SELLING SECURITIES THROUGH DEALERS 333 

in quotations. Their calculation is that sooner or later out- 
siders will be attracted by the movement and will endeavor to 
go along with it. By gradually feeding out or repurchasing 
the security in which they are interested, they may be able to 
clear a large profit for themselves. 

A third group of speculators consists of men who possess 
a real or fancied knowledge of the intrinsic value of a 
security, and who buy or sell when the market price is a 
considerable distance away from what they believe to be the 
normal price, in the expectation that at some later date the 
normal price will be reached and they may realize a profit. 
Included in this group are officers and directors of corpora- 
tions the securities of which are listed on the exchange, who 
should be in position to know more about the real standing 
and probable future showing of their corporation than any- 
one else. Unfortunately for these men, it frequently happens 
that they do not give proper weight to general market 
influences which affect the whole general level of security 
prices. It is not at all an uncommon case for a man who is 
thoroughly well acquainted with a given corporation to form 
an entirely mistaken idea as to the market value of its 
securities. 

A fourth group of speculators consists of the "lambs" who 
are not equipped with the experience and insight of the "floor 
traders," do not possess the knowledge of market conditions 
and financial resources of the larger operators, and are not 
acquainted with given securities as corporation officials are. 
For the most part they simply gamble on the strength of 
"tips" or of hazy impressions; and it can never be more than 
a temporary accident if they happen to make profits. The 
number of these people and the volume of their transactions is 
often exaggerated, but their losings nevertheless provide a 
steady source of revenue for the better informed and more 
skilful speculators. 



334 SECURING CAPITAL 

Making a Market 

In disposing of securities through stock exchange opera- 
tions, it is essential, first of all, that public interest should be 
aroused and that the volume of transactions should be of 
sufficient size to attract attention; otherwise the speculative 
buying, which constitutes the great bulk and which must be 
relied upon to take the new securities off the hands of the 
syndicate managing the flotation, will be lacking. 

"Making a market" is accomplished chiefly through two 
lines of effort ; first, through providing for a sufficient volume 
of transactions to arouse the interest of brokers and pro- 
fessional stock market operators who in such a case will buy 
and sell in the hope of making substantial profits out of the 
fluctuations. When the market for a given issue is success- 
fully manipulated, the volume of transactions will become 
so large that the syndicate carrying through the flotation — 
which probably will be engaged simultaneously in buying and 
selling so as to gain a control over the price — should find 
it possible to sell every day during the movement, a little 
more than it buys. Thus it will gradually get rid of its 
own holdings without causing a fall in the price. At the 
same time, through direct sales outside the exchange, which 
will be facilitated by the excellent quotations on the exchange, 
it will probably dispose of the rest of its holdings. 

The second essential factor in making a market is favor- 
able publicity. When a new security is to be brought out 
and listed on the stock exchange, it is generally the case that 
for some weeks or possibly for some months in advance, the 
financial press and the financial pages of the daily newspapers 
are liberally supplied with press notices intended to arouse 
glowing visions of the prosperity of the corporation. Let 
us take a concrete example. Beginning early in the summer 
of 19 14, news items began to appear relating to the intended 
formation of the Sterling Gum Company, which was to put 



SELLING SECURITIES THROUGH DEALERS 



335 



on the market some new brands of chewing gum. The 
names of some business men of good standing were men- 
tioned as being the organizers and prospective directors of 
the new company. Throughout the summer and fall, such 
items as the following frequently appeared: 

An official of the Sterling Gum Company says: "Our 
selling campaign is now well under way. The reception 
accorded our brands, both new and old, here and in 
Canada, has exceeded our greatest expectations. Repeat 
orders within a few days after first allotment have been 
the rule rather than the exception." 

The Metropolitan Tobacco Company, the largest 
tobacco jobber in the United States, is handling Sterling 
brands in the New York district, and its report to the 
Sterling Gum officials has been of unusually big sales 
in and about New York City. 



Sterling Gum Company has one brand which it is sell- 
ing exclusively in Canada. This brand is manufactured 
in Toronto. Its selling agent there reports its initial sale 
the largest of any newly introduced gum in the history 
of the Dominion. Those who are directing the affairs 
of the Sterling Gum Company state that the "inserts" 
similar to those being used by many of the large tobacco 
companies, are proving as efficient a means of pushing 
new gum brands as they proved in the selling campaign 
of brands of tobacco goods. 



The new plant of the Sterling Gum Company in Long 
Island City will be a five-story factory building on the 
south side of Harris Avenue between Ely Avenue and 
William Street. It will be a modern fireproof steel 
structure to cost in the neighborhood of a quarter of a 
million dollars. The Sterling Gum Company has taken a 
long term lease at an aggregate rental in the neighbor- 
hood of $300,000. The plant will be ready for occupancy 
about April t, 191 5. It will be opened with a force of 
over 1,000 employees. 



336 SECURING CAPITAL 

The common stock of this company was finally brought 
out, and perhaps under ordinary circumstances the interest 
that had been aroused would have been sufficient to assure 
it a ready market at a satisfactory price. Unfortunately, 
however, the outbreak of the war and the resulting unfavor- 
able financial conditions upset these calculations, for there 
appeared in the Wall Street Journal of October 15, 1914, the 
following inconspicuous item: 

The Sterling Gum Company syndicate scheduled to 
dissolve on September 15, has been extended to June 
15 next. Notices to this effect will be sent out in a 
few days. This syndicate underwrote $2,000,000 of the 
Sterling Gum Company stock. 

Limitations of Sale Through Stock Exchanges 

On the basis of the brief descriptions above given, it is 
apparent that floating new issues exclusively through stock 
exchange operations is a somewhat uncertain process, and 
moreover is suitable only for securities of a distinctly specula- 
tive character. The expense and risk of floating a com- 
paratively small issue by this method are seldom justified. 

Just how expensive an operation of this character is likely 
to prove is a question that cannot be satisfactorily answered. 
It is evident, however, that even though it may be completely 
and quickly successful, there must be a large outlay for 
brokerage commissions alone. The buying and selling trans- 
actions must total a great many times the nominal value 
of the issue which is being floated, and a commission of J /&% 
on each transaction may easily amount to a considerable sum. 
In addition, the risk undertaken by the underwriting syndicate 
must necessarily be offset by the possibility of earning a large 
profit. On the whole, it is questionable whether the average 
expense of selling by this method is any less than by the 
other methods that have been described. 



SELLING SECURITIES THROUGH DEALERS 



337 



It does not follow, however, that every new security which 
is listed on the stock exchange and immediately becomes 
active is in process of flotation through stock exchange 
manipulation. It is often the case that the security is listed 
simply as an incident to its flotation, and is allowed practically 
to take its own course except for receiving some support 
from time to time in case its price tends to sag below the 
direct "over the counter" price. In this case the fact that the 
security is listed, and that its quoted price is slightly above 
the "over the counter" price, is a powerful and legitimate aid 
in selling the security. There can be no question but that 
any security which enjoys the advantage of being listed and 
of having a regular market is, for that very reason, worth 
more than a security of equally high intrinsic value which is 
not so readily marketable. 

It should be mentioned in this connection, that the faulty 
banking system which existed in the United States prior to 
the inauguration of the Federal Reserve Act in November, 
19 14, tended to concentrate call loan money in the New York 
market and thereby fostered speculation on the New York 
Stock Exchange. The result was an overconcentration of 
interests on a limited number of large and highly speculative 
issues, to the detriment of other issues. On the London and 
other stock exchanges this tendency is not so prominent; on 
the contrary, vast numbers of securities issued by govern- 
ments and corporations in all quarters of the world are dealt 
in, and the interest of the purchasing public is spread with 
some degree of uniformity over the whole list. 

It is greatly to be hoped that under the new banking system 
in this country a similar decentralization of call loan money 
and of speculative interest will take place. If this proves to 
be the case the great gambling operations in speculative 
issues will become a less prominent feature of the stock 
markets and the volume of actual buying and selling will 



338 SECURING CAPITAL 

proportionately increase. This tendency will favor many of 
the smaller stock exchanges of the country, and especially 
will tend to favor the smaller corporations which have previ- 
ously been unable to secure for themselves the attention that 
their securities deserve. 



.CHAPTER XV 

UNDERWRITING 

Origin of Underwriting 

The practice of underwriting security issues has been re- 
ferred to from time to time in previous chapters. It has been 
assumed that every reader is acquainted in a general way with 
the meaning of the term, but a more detailed discussion is 
presented in the present chapter. 

The practice of underwriting arose in connection with 
shipping ventures during the seventeenth century. The lead- 
ing ship merchants of London were accustomed to assembling 
in Lloyd's Coffee House to transact their mutual business. In 
the course of time, the custom arose of dividing the risk of 
venturesome voyages among a number of different merchants, 
each one agreeing to stand a fixed share of the loss or to 
receive a proportionate share of the profits. The contract to 
this effect was passed about and each merchant who agreed 
to it wrote his name under the contract — hence the word 
'"underwriting." As is well known, the term is used chiefly 
in relation to the distribution of insurance risks ; though when 
applied to bond and share issues the essential thought is the 
same, namely that of distributing the risk. 

Perhaps it would be more correct to say that the under- 
writing contract generally relieves the corporation which issues 
the security of all risk. t£As will be explained a little later, 
there are a number of different types of underwriting agree- 
ments, but they all possess the feature that a banking house or 
a group of banking houses undertakes that the corporation 
receive not less than an agreed sum for the whole issue within 
a fixed period. The underwriters obligate themselves to take 

339 



340 



SECURING CAPITAL 



over the issue themselves in case it cannot be sold to the public 
above the agreed price. 

Importance of Underwriting in Present-Day Financing 

The advantages of this arrangement to a corporation are 
well worth a considerable sum of money. In the first place, 
an issue once underwritten is an assured success. The cor- 
poration may at once proceed with whatever projects the fresh 
capital is designed to finance. There is no tedious and costly 
period of waiting during which the securities are in process 
of being sold. Many new enterprises are of such a nature that 
time is an important element in making them successful. If, 
for example, a new plant is being built in order to handle 
certain contracts, or if an effort is being made to forestall 
competition, it might be fatal to the project if its inception 
were delayed until after all the stock or bonds have been sold. 

A second highly important advantage is that underwriting 
assures success in raising the entire sum called for. Frequently 
any amount less than the entire sum would be a burden rather 
than a source of strength to the corporation. For example, 
a company operating department stores intends to establish 
a new store on a large scale in another city. The stores pre- 
viously owned are developed as far as can profitably be done. 
To establish the proposed new store with insufficient capital 
would be merely to make it second-rate and to invite quick 
failure. 

Let us suppose that the company, which needs $1,000,000 
for the new store, authorizes an issue of additional stock for 
that amount, and sells only one-half the stock, thus raising 
$500,000. It is then in a position where it can go neither 
forward nor backward. It cannot very well return the money 
which has been raised, nor can it proceed with the upbuilding 
of the new store. It is possible, in a case of this kind, to take 
subscriptions to the new issue, the subscription agreement pro- 



UNDERWRITING 341 

viding that it shall not be binding unless the complete issue 
is subscribed for within a given period. However, this intro- 
duces an element of uncertainty that interferes with effecting 
the sale of the security issue. Underwriting protects the cor- 
poration against all risk and difficulty of this nature. It can 
be certain of receiving the amount of capital that is agreed 
upon within a definite period. 

Incidentally, the underwriting agreement carries with it 
the advantages that go with all other arrangements whereby a 
banking house agrees to market the securities of a corporation. 
The corporation gets the benefit of the specialized experience 
and judgment of the bankers, and thus the risk of making a 
serious error in the form or in the price of the new security 
is reduced to a minimum. 

Not only is the underwriting agreement advantageous to 
the corporation, but also to the purchasers of the security issue. 
In the first place, the fact that an underwriting syndicate has 
been formed — provided ( it is made up of first-class houses — ■ 
is in the nature of a guarantee that the security is sound. A 
still greater advantage is the insurance of the purchaser of the 
security against the same contingencies which would be harm- 
ful to the corporation ; for it must be borne in mind that the 
moment the purchaser becomes a stockholder or a bondholder 
in the corporation, he begins to share in its good or evil 
fortunes. If the corporation, therefore, is injured by dragging 
out the sale of a new security issue over a long period, or by 
bringing out a security issue which finally is not entirely dis- 
posed of, the purchaser of the securities is one of the sufferers. 
It is, therefore, to his advantage that the issue should be under- 
written and its success thereby assured. 

The Underwriting Syndicate 

We have seen that originally underwriting consisted in 
the distribution of the risk among several different merchants. 



342 / SECURING CAPITAL 

This remains a characteristic feature of present-day financial 
underwriting. It is true that the term is frequently applied 
to an agreement between a corporation and a single banking 
house, under which the banking house agrees to take over a 
block of securities at a given price. A transaction of this type 
may better be called a sale — or, at any rate, a contract of sale — 
rather than an underwriting. However, an arrangement of 
this kind, in which only one banking house is involved, is 
practically unknown except to cover issues of small size. A 
foreign government loan of as much as $6 ? ooo,ooo was recently 
"swallowed" — to use the bankers' own term — by a single bank- 
ing house ; but ordinarily only issues of less than $2,000,000 to 
$3,000,000 are taken up by an individual house. 

Usually, however, the original agreement is made between 
the corporation and a single banking house, and the banking 
house afterwards distributes proportions of the risk and profits 
among other banking houses. All these houses, working 
together, thus form themselves into the underwriting syndicate. 
Most of the larger banks and financial houses in the chief 
centres make it their practice to work in harmony with each 
other. The organization of the syndicate and the terms of the 
syndicate agreement will be taken up a little later. 

There are two reasons which make it preferable for a 
banking house to join a considerable number of syndicates 
rather than to put through a smaller number of transactions 
in which it assumes for itself all of the risk and all of the 
profits. The first and obvious reason is in order to minimize 
risk. A false step in a syndicate — even though the syndicate 
should fail ultimately — would not prove ruinous; whereas the 
failure of a good-sized issue in which only one house was 
concerned might not only tie up enough capital to wreck the 
house, but might also wreck its reputation, which is an asset 
of even greater importance. The second motive for preferring 
syndicate participation is that it enables the bond and brokerage 



UNDERWRITING 



343 



houses to offer to their customers a well-diversified list of 
securities. The general retail security merchant should be 
prepared to deliver to a customer any kind of security the 
customer may fancy, just as the department store is ready to 
sell anything from pins to locomotives. 

Community of Interest Among Underwriting Houses 

If one banking house closes a good contract with an excel- 
lent chance of profits, others are usually invited to come in as 
members of the underwriting syndicate to handle the contract. 
In this way all of them more or less take part in all the 
important underwritings. There is, of course, no formal 
agreement to this effect but it is tacitly understood that when 
one house permits its neighbor and rival to join in a profitable 
underwriting, the favor is to be returned at the first opportu- 
nity. So well-understood is this arrangement, that frequently 
— in the Wall Street district at least, and probably in other 
centres — the firms which become members of an underwriting 
syndicate are scarcely consulted. The banking house which has 
made the agreement with the corporation and which is man- 
aging the syndicate, simply distributes the issue as it thinks 
best and notifies each of the participants making up the syndi- 
cate. Most of these somewhat peremptory invitations are 
profitable, and it is safe to say that invitations of this kind from 
one of the three or four most important banking houses are 
seldom, if ever, refused. In testifying during the insurance 
investigation some years ago, J. P. Morgan, the elder, ex- 
plained that some highly important syndicates involving tens 
of millions of dollars were organized by his firm through the 
simple process of calling up the selected list of participating 
houses on the telephone and advising how much each was ex- 
pected to subscribe. 

An important result of this "community of interest" ar- 
rangement is that it removes the occasion for keen competition 



344 



SECURING CAPITAL 



among the leading banking houses. It is comparatively of 
minor importance whether one house or another carries 
through the negotiations with the issuing corporation and 
becomes the active manager of the syndicate, because in any 
case each of the important houses will participate in the syndi- 
cate and in a fair share of the profits. 

In New York it is well understood that negotiations for 
the flotation of an issue of any size should be taken up with 
only one of the important banking houses at a time. In case 
negotiations with one house fail definitely, they may possibly 
be taken up with another house. But the important banking 
houses will not directly compete with each other ; nor will one 
of them even interfere with suggestions or investigations while 
another has the matter in hand. No doubt much the same kind 
of a tacit understanding exists in most financial centres. Many 
business men who are accustomed to dealing under highly 
competitive conditions resent the existence of this invisible 
and indefinite bond union among the large underwriting 
houses. If they are bringing an issue into the market to be 
sold, naturally they would like to have it eagerly bid for. 
They are looking for competition and they find a silent, but 
inflexible, understanding. Much of the outcry of the last few 
years against the so-called "money trust" is an expression of 
this resentment. 

The bankers, on the other side, claim first of all that un- 
checked competition would be disastrous not only to them, 
but also to the whole business community which they serve. 
It would invariably mean reckless extension of credit, over- 
financing, and disregard of conservative principles. They 
advance the claim, further, that they make no oppressive terms 
or restrictions and that the present situation leaves room for 
difference of opinion, thus preventing the establishment of a 
complete monopoly. Finally, they assert that the relations 
between the financial managers of a corporation and the bank- 



UNDERWRITING 



345 



ing house which handles the security issue ought to be of 
intimate, permanent, and semi-professional nature. A cor- 
porate official ought to pick out a banker in whom he has 
implicit confidence, just as he picks out a physician or a lawyer 
in whom he has confidence, and ought to stick to the man 
or the firm he has picked out until that confidence is shaken or 
there is some real reason for disagreement. In that case, he 
should cut off all relations as quickly as possible and entrust 
his financial affairs to some other banking house. In other 
words, the banker feels that he is rendering a personal and 
partly professional service rather than merely buying and re- 
selling a certain commodity. 

Syndicate Agreements 

There are four distinct types of agreements between an 
underwriting syndicate and the corporation which puts out the 
underwritten issue. Possibly other variations from these basic 
types could be found. 

i. The corporation may itself sell the issue and the syn- 
dicate may simply insure that the whole issue will be disposed 
of w T ithin a given time at a minimum price. The corporation, 
we will say, is bringing out an issue of $1,000,000 6% bonds, 
which it offers at par. The underwriting syndicate may agree 
that it will take any bonds left unsold at the end of the year 
at a special price of 90. The syndicate would receive a com- 
mission of 2 to 5% for making this agreement. If the issue 
were successfully sold, the syndicate would merely collect and 
distribute its commission and dissolve. If the issue at the 
agreed price were unsuccessful, the syndicate would take over 
the unsold balance and dispose of it. This type of agree- 
ment is now uncommon except when a corporation has given 
a subscription privilege to its own shareholders but is appre- 
hensive that the offer will not be taken up in full. 

2. A banking house may conclude an arrangement with a 



346 SECURING CAPITAL 

corporation to handle the sale of a block of securities and may 
afterward call in other banking houses to take over certain 
proportions of the risk and of the profits. The corporation, 
however, has no dealings with the syndicate, as such, but only 
with the original underwriter which becomes the manager of 
the syndicate. 

3. The syndicate may be formed before a final agreement 
with the corporation is signed, and the agreement may be 
directly between the corporation and the syndicate, though the 
management of the whole transaction and the actual selling 
of the securities may be left in the hands of the one banking 
house which has taken the initiative. This banking house 
carries through the sale of securities and does not distribute 
them to the other members of the syndicate unless the sale 
is in whole or in part unsuccessful. 

4. The agreement is made between the syndicate as a 
whole and the issuing corporation and the securities are at 
once distributed among the members of the syndicate in pro- 
portion to their participations. This form of underwriting is 
almost in the nature of a joint purchase, each of the banking 
houses being expected to act independently in disposing of 
its proportion of the issue. This is perhaps the most common 
and most useful type of agreement for handling large issues. 

It is clear, from the brief descriptions above given that the 
term "underwriting" is used in a loose sense. It is, in fact, 
often difficult to distinguish in practice between underwriting 
a block of securities and purchasing a block of securities. 
Even when a single banking house takes over outright the 
complete security issue and pays to the corporation the agreed 
price for this issue, the transaction is commonly referred to 
as "underwriting." 

Whatever the type of syndicate issue may be, there is al- 
ways this common characteristic : that the active management 
is unreservedly in the hands of the banking house which 



UNDERWRITING 



347 



organized the syndicate. In the published agreement, for 
example, of the syndicate which underwrote the retirement 
of United States Steel Corporation preferred stock in 1902, 
it is provided that : 

J. P. Morgan and Company shall be sole managers 
of the syndicate, and in behalf of the syndicate they 
may make any and all arrangements, and may perform 
any and all acts, even though not herein provided for, in 
their opinion necessary or expedient to carrying out 
the provisions of this agreement; or to promote or to 
protect what they deem to be the best interests of the 
syndicate. The enumeration of specific powers in this 
or any other article of this agreement, shall not be 
construed as in any way abridging the general powers 
of this article intended to be conferred upon or reserved 
to J. P. Morgan and Company. 

Throughout the agreement other reservations of the same 
general character abound, and in this respect the contract is 
typical of most underwriting syndicate agreements. 

In return for its special efforts the managing house usually 
receives a commission as manager, which is deducted from 
the syndicate profits before distribution of the remaining 
p r ofits is made among all the members of the syndicate. This 
payment to the managing house varies a great deal, depending 
on the profitableness of the transaction. It will probably 
average 1 to 2 c /c on the par value of the block of securities. 

It is very rarely the case that these syndicate agreements, 
no matter how informal they may be, give rise to serious 
misunderstanding or litigation. This is, no doubt, due primarily 
to the high standards of commercial honor which prevail 
among the bankers who are active in underwriting syndicates. 
One of the rare instances of litigation arose in connection with 
the syndicate formed to underwrite the bonds issued at the 
organization of the Mount Vernon- Woodberry Cotton Duck 
Company. This syndicate was managed by the Continental 



348 SECURING CAPITAL 

Trust Company of Baltimore. Two New York banks, the 
Merchants Trust Company and the Central National Bank, 
each of which had subscribed $300,000, sued the Continental 
Trust Company in the United States District Court for the 
return of their subscription. They alleged fraud and mis- 
statements. They claimed that the mills were not worth what 
they were represented to be and were not earning what had 
been stated; further, they claimed that the Continental Trust 
Company, through its ownership of $1,000,000 of income 
bonds, had been especially favored under the terms of exchange 
that had been agreed to in forming the combination. The 
case was never brought to trial and was finally settled out of 
court.* 

The commissions of underwriting syndicates may vary all 
the way from 1^2% to 10%, or even more. If the com- 
missions are high, it is quite the custom to make them payable 
partly in securities. In 1910, for example, the newly organized 
International Cotton Mills Corporation was in need of working 
capital, which it secured by selling to Blair and Company 
$2,000,000 6% five-year notes at par, in consideration of a 
commission of $1,000,000 par value of the corporation's com- 
mon stock. These notes were offered to the public by Blair 
and Company at 98. In 1898 the Union Pacific Railroad 
Company paid a syndicate $5,000,000 of preferred stock, then 
quoted at 59, for underwriting a subscribed capital of $15,000,- 
000. This amounted to a commission of I9%.f These 
examples, of course, refer to companies which at the time did 
not have a high credit standing, and are not to be taken as 
typical. 

Speculative Underwriting 

Most of the preceding remarks in this chapter refer to 
the underwriting of high-grade bond and preferred stock 



*Dewing's "Corporate Promotions and Reorganizations," p. 350. 
f Stuart Daggett's "Railroad Reorganizations," pp. 347, 348. 



UNDERWRITING 



349 



issues by financial houses of the highest standing. However, 
this is by no means the only situation in which underwriting 
is frequently advisable. In addition to assuring success in 
disposing of large blocks of securities for established 
corporations, syndicates may be formed for the purpose of 
underwriting the issues of new or of reorganized corporations. 

In any of these three cases the issue that is being brought 
out may be of a speculative character and the syndicate itself 
may be far less stable and more speculative than has been 
assumed in what has been said above. Frequently underwrit- 
ing syndicates are made up, not of first-class banks or banking 
houses, but in whole or in part of individuals and of second- 
rate houses. Sometimes even the best houses are led into 
mistakes which may cause financial loss and in addition prove 
harmful to their reputation. 

At the time the United States Realty and Construction 
Company was organized, the large working capital which was 
thought to be necessary for the company was obtained through 
a syndicate. $11,000,000 was subscribed to this syndicate. 
The members paid in 20% of their subscription in cash, gave 
their notes for 60%, and the bank advanced the remaining 
20% on the syndicate account. The syndicate received $100 
in preferred stock and $100 in common stock for each $100 
in cash which it furnished. The subscribers included some of 
the strongest concerns in New York. The managers received 
as their compensation $220,000, or 2% of the subscriptions to 
the syndicate. 

On the basis of the first quotations for the shares of the 
United States Realty and Construction Company, the syndicate 
had a paper profit of a little less than one million dollars. 
Although the company had the support of the strongest in- 
terests, its securities immediately began to decline in market 
value and by the end of six months it still had on hand a large 
proportion of preferred and common stocks which it had re- 



350 



SECURING CAPITAL 



ceived and which, at current quotations, could be sold only at 
a heavy loss. 

On September n, 1903, the syndicate was dissolved. The 
managers of the syndicate had originally acquired 110,000 
shares of preferred and 110,000 shares of common. Soon 
after organization the managers sold 67,000 shares of common 
at $37.50 and refused an offer of $35 a share for the remaining 
43,000 shares. They used a large part of the proceeds in 
purchasing 27,000 shares of common and 17,000 shares of 
preferred at prices much less than they had originally paid. 

At its dissolution, after the managers had taken $220,000 
for their services, the syndicate was in possession of 127,000 
shares of preferred, 77,000 shares of common, and $675,000 
in cash. Approximately $500,000 of the cash had been re- 
ceived from dividends on the preferred stock. On the date 
of dissolution the preferred stock was quoted at $36 a share 
and the common stock at $6.50 a share. Each member of 
the syndicate received for each $1,000 contributed, $1,155 m 
preferred stock, $702 in common stock, and $61.66 in money, 
of which $45 was furnished by dividends on the preferred 
stock held by the syndicate. Eliminating this $45, and figuring 
the shares at their market values, each member of the syndicate 
got back less than one-half of the amount he had contributed. 
Furthermore, a week after the dissolution of the syndicate, 
the fourth dividend on the preferred stock was passed and the 
stock went to yet lower levels.* 

Dewing cites, also, another instance of even more disas- 
trous failure. At the time of the incorporation of the United 
States Shipbuilding Company in 1902, the promoters were 
required to sell enough first mortgage bonds between June 14 
and August 1 1 to have in hand $7,500,000 cash by the latter 
date. However, the public offering of the bonds was a failure, 
inasmuch as only $500,000 out of the total offering of $9,000,- 



*Dewing's "Corporate Promotions and Reorganizations," pp. 233-, 235, 238. 



UNDERWRITING 



351 



000 was subscribed for. The promoters therefore fell back 
upon their French and American underwritings of the bonds. 

Here ensued a very amusing correspondence by cable be- 
tween the promoters and the French underwriters, most of 
whom were not bankers but individuals untrained in business 
affairs. The Frenchmen declined to meet their alleged ob- 
ligations. They asserted that the promoter had assured them 
that their underwritings would never be called and had later 
cabled them that the public offering of the bonds was a success. 

The American underwriters, who were better accustomed 
to such transactions, took their medicine and accepted about 
$4,500,000 of the bonds at 90. The promoter, John W. 
Young, went to Paris in a strenuous but unavailing attempt 
to secure payment from the French underwriters. 

In the meantime, Mr. Dresser negotiated, with the as- 
sistance of Mr. Schwab and J. P. Morgan and Company, loans 
of about $2,500,000 under personal indorsement of himself 
and Mr. Nixon, on the credit of the Trust Company of the 
Republic, and on the basis of the French underwriting. When 
the French underwriters still refused to take up their share 
of the bonds, the results were disastrous for the promoters.* 

Still another example is illuminating. In 19 10 it became 
evident that the Consolidated Cotton Duck Company was in 
need of a considerable amount of new capital, both for the 
acquisition of additional properties and for investment in its 
own mills. It was determined that it would be advisable to 
secure a majority of the stock for a group of Bostonians, who 
desired to become active in the company. Three syndicates 
were formed as follows : 

May 27, 1910, in order to acquire 53% of the Consoli- 
dated Company's stock and a supply of between two 
million and three million dollars working capital. 



•Dfcwing's "Corporate Promotions and Reorganizations," pp. 489, -49°. 



352 SECURING CAPITAL 

April 17, 191 1, in order to purchase common stock only 

of the new company. 
April 27, 191 1, to acquire a minority of Consolidated 

stock and supply $500,000 new money. 

On May 27, 19 10, Augustus P. Loring, a Boston lawyer, 
and Joseph B. Crocker, a stock broker, were made syndicate 
managers. Each man received $12,500 in compensation for his 
services, in addition to which Mr. Loring received a fee for 
his legal services in connection with the incorporation of the 
new company. Much of the work of organizing the syndi- 
cate and of carrying through the reorganization of the com- 
pany was taken care of by Samuel Untermyer, who also used 
his influence to secure banking connections for the company. 

The syndicate agreement of May 27, which was marked 
"confidential," contained the following provisions: 

1. The new International Company was to issue 52,875 

shares of preferred and 45,375 shares of common 
to the managers of the syndicate. 

2. The syndicate was to acquire 61,000 shares of pre- 

ferred and 71,000 shares of common of the Con- 
solidated Cotton Duck Company ($50 par value). 

3. The syndicate was to purchase the preferred and com- 

mon stock of the International for $5,093,000, which 
the subscribers were to take in the proportion of 
ten shares of preferred and ten shares of com- 
mon, for each $1,000 of their subscription. 

4. The managers were authorized to sell the excess of 

1,945 of preferred stock and to purchase enough 
common stock to make their holdings of both 
kinds of stock 50,930 shares. 

The Loring-Crocker syndicate of the International Cot- 
ton Mills Corporation was unfortunate in its operation. Syn- 



UNDERWRITING 353 

dicate subscribers were allotted $100 in preferred and $100 
in common stock, for each $100 cash. Three years later, 
in the reorganization, the old preferred stock was given $jj 
in new common stock of the new International, and the old 
common stock was given $16.33 m new common. For each 
$100 cash put in by a syndicate subscriber, therefore, he 
received, in 19 13, $93,33 in new common stock, worth about 
$30 a share on the open market. For each $100 put in, the 
syndicate subscriber received after three years $28. This 
was not due to failure of the company but rather to mis- 
calculation at the beginning as to the amount of fresh capital 
that would be required in order to rehabilitate the property 
of the company. * 

It would be difficult to give any detailed information con- 
cerning the inner workings of these speculative syndicates. 
Their operations have not been in any sense standardized. 
Each syndicate formed for speculative purposes drives its 
own bargain. Inasmuch as its compensation ordinarily comes 
in the form of securities rather than of cash commission, 
its risk is large and it is generally entitled to a correspond- 
ingly large block of stock. The operations of a syndicate of 
this character in connection with the promotion of a new cor- 
poration are really a part of the work of promotion and have 
been referred to under that head. We shall have occasion in 
a later chapter to refer to the activities of underwriting syn- 
dicates in connection with reorganizations. 



*Dewing's "Corporate Promotions and Reorganizations," pp. 382, 403. 



Part IV — Internal Financial Management 



CHAPTER XVI 

INVESTMENT OF CAPITAL FUNDS 

Estimating Capital Requirements 

Having organized a corporation, issued the proper se- 
curities, carried through the process of promotion, and 
disposed of the securities, what is to he done with the capital 
that has thus been secured ? 

Presumably this question will have been answered before 
the financial plan was formulated ; that is to say, the amount 
of capital that would be required was first of all estimated and 
the financial plan was made to fit this estimate. Right here 
is a frequent source of serious error. The capital required is 
often not estimated at its proper amount. It is easy enough, 
usually, to calculate what will be needed for plant and 
machinery, road-bed and equipment, office furniture, or what- 
ever the fixed assets of the business may be. In addition, 
however, there are two requirements of uncertain amount 
— for working capital and development expenses. 

Sufficient working capital must be provided in order to 
take care of the normal process of purchasing raw materials 
and supplies, turning out finished products, selling the 
products, and waiting for payments to be made. If the 
original estimates of working capital are insufficient, some 
emergency measures must be resorted to or the business will 
come to a dead stop. 

The losses and expenses of development are generally 
underestimated. Every new organization must be in part an 

355 



356 INTERNAL FINANCIAL MANAGEMENT 

experiment. Men will be employed who are unsuited for their 
positions ; methods of production and of sale will be tried that 
must be discarded; machinery will be installed that proves 
worthless; advertisements and sales booklets will be written 
that do harm rather than good. If the enterprise is basically 
sound, all these expensive losses may properly be charged as 
a part of the initial expense of getting the business on its feet. 
The experience of generations has proved that mistakes of 
this kind are unavoidable and they should be provided for in 
the original estimates of capital expenditures. 

These remarks apply— though with somewhat less force — 
to the planning of extensions and betterments for which fresh 
capital is raised. It is an every-day. occurrence for a manu- 
facturer to plan to put up a new building and install new 
machinery that will increase his capacity, let us say, 50%, and 
to overlook entirely the necessity for a corresponding 50% 
increase in his working capital. Also, he frequently overlooks 
the probability of experiments and losses in construction of 
the plant and in developing the sales and administrative or- 
ganization which will take care of the increased output. 

Fixed Capital and Working Capital 

The distinction between fixed capital and working capital 
is often not clearly understood. There would be much less 
confusion if it were possible to drop the adjective "working," 
which in this connection is meaningless, and substitute the 
word "revolving." "Fixed" capital and "revolving" capital 
are almost self-explanatory. The "fixed" capital is invested 
in the plant, equipment, and other forms which cannot be dis- 
posed of without breaking up the business. The "revolving" 
capital is invested in raw materials, in stocks of partly finished 
and finished products, in accounts receivable, in salable 
securities, and in cash. Capital in all these forms is constantly 
being converted — after whatever alterations in form are 



INVESTMENT OF CAPITAL FUNDS 357 

necessary — into cash, and this cash flows out again in exchange 
for other forms of working capital. Thus, it is constantly re- 
volving; or, to use a more common expression, it is being 
"turned over." 

Note that it is said in the preceding paragraph that the 
working capital is invested in cash or in various forms of 
assets that are readily convertible into cash. This is not 
equivalent, however, to saying that the total value of the cash 
or cashable assets measures the amount of the working capital. 
On the other side of the balance sheet, there is a group of 
liabilities, consisting chiefly of short-time bank loans and 
accounts payable, which must be deducted from the total of 
the working assets in order to determine the net working 
capital. If this were not done, a firm which had managed 
to pile up a great quantity of merchandise debts, might be 
considered, looking only at its assets, to be well provided with 
working capital ; yet the truth might be that it had little or no 
surplus of working capital above its current liabilities. 

Mention is frequently made of "quick assets" and "quick 
liabilities," and the question is sometimes raised as to the 
distinction between them and "working" or "current" assets 
and liabilities. As a matter of fact, there is no clear-cut or 
authoritative distinction. In a general sense, however, the ad- 
jective "quick," used in this connection, is reserved for assets 
or liabilities that have only a short period — say 30 days or 
less — to run. A stock of finished products which are regarded 
as immediately salable might be listed as a quick asset, whereas 
a stock of half-finished products or of raw materials could not 
be described as more than a "working" or "current" asset. 

Necessity for Adequate Working Capital 

The history of the Westinghouse Electric and Manufactur- 
ing Company offers some of the clearest and most striking 
illustrations of the necessity of using care in the investment 



358 INTERNAL FINANCIAL MANAGEMENT 

of capital funds, and especially of the advisability of keeping 
on hand an ample supply of working capital. The illustrations 
are especially apt, because this company has always carried 
on an extensive and profitable business and, so far as industrial 
processes go, has been conspicuously well managed. Yet it 
became financially embarrassed in 1890, and again in 1907, 
both embarrassments being the direct result of rapid expansion 
of business, leading to a large investment in fixed assets and 
a relative diminution of working assets. 

When it was realized by the officers of the company in 
1890, that the steady growth of the business was leading to 
a dangerous financial situation and larger and larger current 
obligations which could not be met were piling up, it was 
decided, as an emergency measure to increase the stock from 
$5,000,000 to $10,000,000 and to offer the additional $5,000,- 
000 to previous shareholders at the bargain price of $40 a 
share. Radical proposals of this kind, being obviously in- 
tended to relieve pressing demands, naturally arouse distrust. 
The net amount realized by the company from this sale was 
only about $1,400,000, which was not enough to create an 
adequate working capital. In fact, the situation rapidly be- 
came worse. In the summer of 1890 the company had 
outstanding about $2,000,000 of notes covering merchandise 
purchases and bank loans. By the early part of 1891 the 
floating debt had become $3,300,000. A financial reorganiza- 
tion, with its attendant frictions and losses, was then recognized 
as inevitable. 

After the reorganization of 1891 the company continued 
to expand its business and as a result continued to meet serious 
financial problems. These problems were not wholly the out- 
growth of internal development, but were in part a necessary 
feature of the electrical industry as a whole. The progress 
of electrical invention required continual and extensive in- 
vestment of capital for generating stations, transmission lines, 



INVESTMKAT OF CAPITAL FUNDS 



359 



and electrical machinery. Throughout the country small 
lighting, power, and traction companies were endeavoring to 
sell their securities, frequently without much success. Yet, 
it was evident that their projects in most cases were sound 
and it seemed to be necessary for the Westinghouse Company, 
in order to keep up and develop its sales, to assume a portion 
of the burden of financing its customers. This it did by ac- 
cepting in payment for equipment the notes of these local 
companies, generally secured by a deposit of their bonds and 
stocks as collateral. The Westinghouse Company then relied 
on discounting these notes, which in normal times could 
readily be arranged for. At periods of credit restriction, 
however, the notes became unmarketable and the Westing- 
house Company itself was hard pressed for funds with which 
to meet its own obligations. 

Between 1891 and 1907, this growing problem was success- 
fully solved by repeated sales of capital stock. In 1896 the 
authorized capital was increased from $10,000,000 to $15,- 
000,000, and in 1901 from $15,000,000 to $25,000,000. At 
the same time, the company was putting out several million 
dollars of collateral and debenture bonds. Nevertheless, notes 
payable grew steadily until they aggregated $5,000,000 in 
1 90 1, and $14,000,000 in 1905. 

Dewing has calculated this company's ratio of current 
liabilities to current assets, of current assets to total assets, 
and of current liabilities to total liabilities, for a number of 
years, as follows :* 

Current Liabili- Current Assets Current Liabili- 
ties to Current to Total ties to Total 







Assets 


Assets 


Liabilities 


Feb. 29, 


1892 


46% 


12% 


6% 


Mar. 31, 


1894 


22% 


34% 


8% 


Mar. 31, 


1897 


106% 


11% 


12% 


Mar. 31, 


1901 


83% 


25% 


21% 



Dev."*ng's "Corporate Promotions and Reorganizations," pp. 165, 200. 



360 INTERNAL FINANCIAL MANAGEMENT 



Mar. 31, 1902 


7i% 


27% 


19% 


Mar. 31, 1903 


88% 


26% 


23% 


Mar. 31, 1904 


101% 


22% 


23% 


Mar. 31, 1905 


163% 


18% 


29% 


Mar. 31, 1906 


66% 


22% 


M% 


Mar. 31, 1907 


96% 


16% 


15% 


Oct. 31, 1907 


86% 


20% 


17% 



When the company was finally compelled in 1907 to confess 
its inability to meet current obligations and a receiver was 
appointed, it was at once agreed on all sides that the prime 
cause of the failure was the lack of sufficient working capital. 

There were, however, some differences of opinion as to the 
extent of the remedy that should be applied. The creditors 
were inclined to demand not only an immediate relief, but a 
radical change of financial policy. Mr. Westinghouse, on the 
other hand, did not believe that there was anything funda- 
mentally wrong with the previous financial policy of the com- 
pany and sought only to extricate it from its immediate en- 
tanglement. It was finally agreed in the interest of the credi- 
tors and of all those who were disposed to insist upon sound 
financing, that a new management should take the reins. 

There are not many instances of large enterprises where 
miscalculation and recklessness in financial affairs were com- 
bined with so much unquestioned ability in handling mechani- 
cal and industrial affairs as in the case of the Westinghouse 
Company. Most large and successful companies have a better- 
balanced management. In small corporations, however, almost 
the same situation is frequently found. The proprietor and 
manager of a business, through his personal energy and re- 
sourcefulness, makes it move ahead and earn good profits. 
To take care of his increasing business he extends his plant 
or builds up his store or in some other form enlarges his 
fixed capital investment and fixed expenses. Thereupon he 
suddenly wakes up to the surprising fact that, on account 



INVESTMENT OF CAPITAL FUNDS 361 

of his prosperity he is pressed harder and harder for funds. 
Unless there is a sudden change in his methods, it is more 
than likely that he will drive rapidly ahead into bankruptcy. 
A sad and constantly recurring spectacle in business life is 
that of a strong man beaten into failure through his own 
energy and ability in producing and selling. 

Some Factors That Affect Working Capital 

How is it possible to calculate in advance how much work- 
ing capital will be required, and thus keep on the safe side 
in providing capital funds ? It is not possible to give an exact 
formula for answering this question, but an approximate an- 
swer in any given case may be reached. 

First of all, it is clear that the proportion of working 
capital in some lines of business is far greater than in other 
lines. This may be illustrated by two extreme cases. Tele- 
phone companies necessarily have large sums invested in wir- 
ing, poles, central offices, and other equipment, but after a 
complete telephone plant has been installed in a community 
the running expenses consist simply in maintenance and in the 
salaries of officers and employees and are comparatively light. 
It is the custom for telephone companies to render bills for 
their services once a month in advance; consequently, all the 
money which is required for running expenses from month to 
month is provided before the expenses are really incurred. 
Evidently there is no necessity in this instance for working 
capital, because the current receipts may safely be depended 
upon to take care of the current outgo. 

On the other hand, let us take a retail store which occupies 
rented quarters. The only fixed assets required will consist 
of store furniture and equipment ; all the other assets, includ- 
ing the stocks of merchandise, the accounts receivable, and the 
cash, are "current" or "working." The greater portion of the 
capital that must be invested in such an enterprise, will consist 



362 INTERNAL FINANCIAL MANAGEMENT 

of working capital. This is true of practically all trading 
enterprises, and is particularly true of financial enterprises. 
Banks must keep all, or nearly all, of their assets in such a 
form as to be converted into cash almost at a moment's notice. 

We may consider, therefore, as the first factor which deter- 
mines the requirements of working capital, the general nature 
of the business. If the business consists merely of leasing real 
estate, providing facilities for transportation, and the like, all 
or nearly all of the investment will be in fixed forms. If the 
business is manufacturing, then a relatively small proportion 
will consist of working capital. If it is trading or financing, 
the chief requirement will be for working capital 

A second factor obviously is the volume of business. Gen- 
erally speaking, the necessity for working capital — except in 
the first class of business above mentioned — will vary in pro- 
portion to the volume of sales. However, this statement as- 
sumes that the other factors mentioned below are uniform in 
their operation. Making the assumption that methods, ex- 
penses, and terms of buying and selling goods and of produc- 
ing the goods are standardized, then we may safely say that 
a 50% increase in output and sales will necessitate a propor- 
tionate increase in working capital. 

But these general remarks as to the nature and volume of 
business are serviceable chiefly in forestalling any misunder- 
standing of what follows. 

The practical considerations that require thought and are 
helpful in making estimates of working capital are: 

1. Length of period of manufacture. 

2. Turnover. 

3. Terms of sale. 

4. Terms of purchase. 

5. Facilities for converting working assets into cash. 

6. Seasonal variations in business. 



INVESTMENT OF CAPITAL FUNDS 



363 



The process of making proper allowances for all these 
factors and of calculating in advance the volume of working 
capital that will be needed is of so much importance that a 
separate chapter is devoted to this subject (Chapter XVII). 

Figuring Fixed Capital Requirements 

It has been noted above that it is comparatively easy to 
calculate, before an enterprise is started, how much of an 
investment will be required in order to provide plant, machin- 
ery, and other fixed capital. This statement is true, assum- 
ing that the enterprise is simple and unified, and that the pro- 
moters and managers know exactly what they intend to do. 

Unfortunately this last condition does not always exist. 
It is a common occurrence to find that a company which was 
started to manufacture a given line of goods, gradually en- 
gages in the manufacture of something entirely different. Or 
it may continue to manufacture a given line but discover that 
some new process is required. Again, after a company has 
once developed its own special business successfully, its man- 
agers almost invariably begin to thirst for fresh conquests and 
begin to take on "side lines." Or, yet again, the managers 
of a company which has proved successful may decide to 
make use of the surplus that is accumulating for their own 
purposes instead of distributing it to the stockholders, and 
may build up a large account under the head of "investments. " 

In figuring the requirements for fixed capital, therefore, 
we have to consider not only the original plant and equipment 
which must be obtained in order to bring the business into 
existence, but also later acquisitions or developments along 
any one of the following lines : 

1. Extensions of the original plant. 

2. Increases or changes in equipment. 

3. Adoption of side lines. 

4. Outside investments. 



364 INTERNAL FINANCIAL MANAGEMENT 

It is in connection with subsequent changes or develop- 
ments along these lines that most of the opportunities for 
mistakes and miscalculations in the investment of capital in 
fixed forms arise. 

Investing Capital in Extensions 

One of the most curious instances on record of a dis- 
astrous investment on the part of a corporation in extending 
its own business, is that of the Assets Realization Company. 
This company was organized for the specific purpose of giving 
financial relief to embarrassed concerns, by taking over the 
assets which they could not otherwise dispose of. It is fre- 
quently possible to purchase from such concerns plants, ma- 
chinery, securities, and other assets of great value, at bargain 
prices. It was the expectation of the organizers of the Assets 
Realization Company that they could take their choice among 
properties thrown on the market in this way, and could re- 
habilitate them or adapt them to other uses or see to it that 
they were managed in a more efficient manner, and in this 
way realize large profits for themselves. The plan seemed 
fundamentally sound, and for some years the Assets Realiza- 
tion Company was successful. As it proceeded, however, the 
company gradually extended its operations into the underwrit- 
ing of securities of new corporations, which for one reason or 
another could not be marketed. Furthermore, it is stated that 
some of the assets which had been taken over from insolvent 
corporations could neither be utilized nor resold, and remained 
as a dead weight on their hands. Eventually the company 
became afflicted with the same disease which it had undertaken 
to cure, and was itself so loaded down with unrealizable assets 
that it was compelled in 1914 to go into the hands of receivers. 
It had extended its business beyond the limits of prudence. 

Another instance of unwise extension was the purchase by 
the United States Cordage Company in 1894, of a binder twine 



INVESTMENT OF CAPITAL FUNDS 365 

mill from the McCormick Harvesting Machinery Company 
for $900,000, of which $500,000 was paid in cash. At the 
same time that the company was paying out $500,000 for this 
mill, it was borrowing $500,000 in order to meet interest 
payments for its funded debt. The new mill could not at once 
become a dividend payer, but rather called for additional in- 
vestment. Therefore it is not surprising that within a short 
time the United States Cordage Company found itself in 
financial difficulties. 

Shortly after the formation of the Consolidated Cotton 
Duck Company in 1905, it was decided to purchase the H. 
Spencer Turner Company, which was the chief selling agent 
for the products of the Consolidated Company. The arrange- 
ment increased the funded debt of the Consolidated Company 
by about $1,500,000, which was its total investment in this 
extension of its business. The chief assets of the Turner 
Company consisted of its good-will and trade connections 
acquired in handling the Consolidated Company's own trade 
marks and brands. Instead of assisting in the marketing of 
the company's products, the move really stimulated competi- 
tion, inasmuch as other selling agents, fearing that their inde- 
pendence might be threatened, began to establish duck mills 
of their own. 

Many large corporations have been led astray by the idea 
that it was necessary for them to extend their business by 
attempting to buy up all competitors. The chief result has 
been that they have "held the bag" for all kinds of trouble- 
making schemes. The contrary policy is ably set forth by 
Chairman A. W. Green in the annual report of the National 
Biscuit Company for 1901. Mr. Green says: 

When the Company started it was believed that we 
must control competition, and to do this we must either 
fight it or buy it. The first meant ruinous war of prices, 
the second constantly increasing capitalization. Experi- 



of)5 INTERNAL FINANCIAL MANAGEMENT 



ence soon proved to us that instead of bringing success, 
either of these courses, if persevered in, must bring 
disaster. This led us to ask ourselves whether the Com- 
pany, to succeed, must not be managed like any other 
large mercantile business. We soon decided that within 
the Company itself we must look for success. 

We turned our attention and bent our energies to im- 
proving the internal management/ to getting the full 
benefit from purchasing our raw materials in large 
quantities, to economizing the expense of manufacture, 
to systematizing our selling department, and above all 
things to improving the quality of our goods. It became 
the settled policy of this Company to buy out no com- 
petition, and to that policy, since it was adopted, we have 
steadfastly adhered and expect to adhere to the end. 

Another very common fallacy on the part of manufactur- 
ers is the notion that they must handle their own retail outlets, 
and to do so must build up a group of chain stores. This 
policy has, in fact, been successfully followed by many im- 
portant companies, such as the George E. Keith Company, 
manufacturers of "Walk-Over" shoes, the Regal Shoe Com- 
pany, a great many brewing companies, etc. In practically 
every such instance, however, it will be found that the policy 
has been followed as a means of protection, not as a profit- 
maker in itself. The dangers of extension along this line 
are not to be minimized. The manufacturer, in the first 
place, is going into a line of business with which he is not 
familiar and where it is difficult to avoid numerous pitfalls. 
In the second place, he is likely to find that the move brings 
him the active hostility of the retailers who have previously 
served as his agencies, thus making it necessary for him to 
develop his chain of stores more rapidly than he had antic- 
ipated and to invest more money than he had counted upon. 

It is a fact often commented upon that successful corpora- 
tions, as they expand, ordinarily tend to earn smaller and 
smaller returns on the actual value of their property. One 



INVESTMENT OF CAPITAL FUNDS 



367 



common explanation is that at the beginning one or two 
managers exercise close personal supervision over the whole 
enterprise, and direct it by their insight and wisdom into 
the most profitable channels; whereas later their duties are 
necessarily delegated in part to men of less ability. The 
economist offers in explanation the "Law of Diminishing 
Returns," which is simply the principle that the most advanta- 
geous opportunities for utilizing capital and energy are taken 
at the beginning, and the less advantageous opportunities 
are left for future development. Yet, neither one of these 
explanations applies in the case of many corporations which 
are ably managed and which continually raise and invest fresh 
capital without decreasing the average rate of return. Mod- 
ern methods of organization and management and the advan- 
tage of being able to employ specialized talent go far toward 
offsetting the first difficulty above named. As to the economic 
principle, it applies, to be sure, but only after the industry 
has been so far developed that all its highly advantageous 
opportunities have been sought out and utilized ; and that 
is a condition which obtains in very few lines of business. 
We may safely infer that one important cause for a decline 
in the rate of return is to be found in the strong tendency 
to make extensions of original businesses along lines that are 
not wisely chosen. The results of each move are not fore- 
seen and calculated with sufficient care. 

As an example of profitable extension on a great scale, 
we may take the case of the General Electric Company. Dur- 
ing the nine years, 1905- 19 13, the capital stock increased 
from $48,000,000 to $101,000,000. However, $23,000,000 
of this increase represented a stock dividend in 19 12 and 
another $10,000,000 was due to conversion of debenture bonds, 
leaving only $20,000,000, or slightly over 40%, as an actual 
increase of invested capital. During these nine years, the 
profits applicable to dividends doubled and the gross sales 



3 68 



INTERNAL FINANCIAL MANAGEMENT 



nearly tripled. All this has been accomplished by steady 
progress in extending the business along lines that had pre- 
viously been mapped out. It is an inspiring record of what 
may be accomplished by persistent and consistent effort. 

Calculating the Extension of Capital for a Bank 

The previous discussion in this chapter has been related 
chiefly to manufacturing and trading establishments. The 
same principles, however, apply to all lines of business. Not 
long ago the president of an important national bank had 
under consideration the advisability of increasing his capital 
stock from $750,000 to $1,000,000, but an analysis of the 
status of his bank and of customary practice in regard to 
banking capital indicated that the increase would be inad- 
visable for the reasons stated below. 

The combined capital and surplus of this bank was found 
to bear a relation to the deposit liabilities of about 1 to 4. 
Other banks in the same city varied from as low as 1 to 3 
to as high as 1 to 5.8. In the City of New York some of 
the large banks have proportions as follows: 

American Exchange National Bank 1 to 5.5 

First National Bank 1 " 9 

Fourth National Bank 1 " 4 

Hanover National Bank 1 " 6.6 

Merchants National Bank 1 " 6.7 

National Park Bank 1 " 6.7 

National City Bank. 1 " 3.7 

National Bank of Commerce 1 " 4 

Although some of these banks have a high proportion, 
it seems to have been the practice of at least two of them 
in recent years to increase their capital from time to time 
so that the proportion existing between the capital and sur- 
plus on the one side and deposit liabilities on the other side, 
would be about 1 to 4. This proportion is generally regarded 



INVESTMENT OF CAPITAL FUNDS 369 

as about correct for a bank doing the ordinary type of com- 
mercial business, though there may, of course, be excellent 
reasons for either a higher or a smaller proportion in par- 
ticular cases. 

In the case under consideration the bank was said by its 
president to be carrying on the ordinary type of commer- 
cial business and to be earning reasonably good but not 
extraordinary profits. If a great many new accounts were 
to be taken over and the deposit liabilities were thus to be 
largely expanded, its present capital would probably not be 
enough to maintain a secondary reserve up to the full re- 
quirements of safety. Unless, and until, this expansion should 
take place, however, there seemed to be no necessary reason 
for increasing the capital so as to reduce the proportion of 
capital to surplus liabilities below the normal ratio. 

There would still remain the question whether the increase 
in capital at this time would in itself be a factor tending to 
bring about a corresponding expansion of current discount 
and deposit business. On this point, the consensus of opinion 
seems to be in the negative. When the capital of a bank is 
not profitably occupied and is not earning a normal rate of 
profit, the directors and managers are immediately put under 
pressure to find employment for the idle funds. This they 
can accomplish either by making investments in securities and 
commercial paper, apart from the paper that comes to them 
from their own customers, or by entering into side-line activi- 
ties, such as underwriting and the like. Neither course of 
action is advisable for a commercial bank. A third possible 
course, which in this case would not be given serious con- 
sideration, is that of soliciting the accounts of new and weak 
depositors. 

On the whole, there is probably no substitute in the bank- 
ing business for the slow and solid growth that naturally 
goes on after a bank has become well-established and is main- 



370 INTERNAL FINANCIAL MANAGEMENT 

taining an untarnished reputation for conservatism mixed 
with a reasonable degree of alertness. Expansion of that 
nature will gradually build up deposit liabilities until it be- 
comes advisable to make a corresponding increase in capital. 
But the chief point to bear in mind is that the expansion will 
come first and the increase in capital will appear as a result, 
not a cause. 

Investing Capital in Betterments 

One of the frequent causes of embarrassment to corpora- 
tions which take over going concerns, or which are formed in 
order to combine previously existing concerns, is the discov- 
ery that the supposed net earnings of the acquired concern 
have been achieved through failure to maintain the prop- 
erty in first-class condition. Of course, if the investigation 
has been sufficiently thorough, this fact will presumably have 
been discovered. However, the truth is that such investi- 
gations frequently are carried on in slipshod fashion, or may 
even be omitted altogether. Cases are not uncommon where 
important combinations have been formed on the strength 
of the unsupported statements of earnings submitted by each 
of the constituent companies. 

When the International Cotton Mills Corporation was 
organized in 1910 to take over the mills of the old Mount 
Vernon-Woodberry Company and the Consolidated Cotton 
Duck Company, it appeared on the surface that sufficient 
new cash and working capital had been provided. It devel- 
oped later, however, that the mills acquired were in a dilapi- 
dated condition and that much larger sums than had been 
anticipated were necessary in order to rehabilitate the prop- 
erty. Due to this weakness, the corporation got into difficul- 
ties, and a reorganization became necessary in 19 13. 

Even within a going and apparently successful corporation 
the same condition mav exist. If the direction of affairs is 



INVESTMENT uF CAPITAL FUNDS 



371 



left wholly in the hands of the active officers they will not 
be over-anxious to disturb their showing of profits by set- 
ting aside ample sums to offset depreciation and to maintain 
the property at its full value. It must be borne in mind that 
making repairs from time to time is not enough. If com- 
petitors are installing new and more efficient machinery, it is 
not sufficient for the company to keep its old machinery in 
good repair. At some later date, when the fact becomes 
known that large amounts are urgently required to bring 
the property back into first-class condition, both the stock- 
holders and the directors are likely to be loath to give up 
or even reduce their dividends to atone for the errors of 
the past. Instead, the idea of raising new capital to provide 
for betterments will meet with favor. It will be argued that 
betterments represent a capital expenditure which may prop- 
erly be provided through the issuance of fresh securities, but 
the expenditures now accumulated in a lump should have been 
met out of profits over a series of years. It is also probable 
that fresh capital invested in bringing the plant and machin- 
ery up to a reasonable degree of efficiency will not materi- 
ally increase the profits, but will merely have the effect of 
preserving and restoring the profits the concern has been 
earning. 

The question as to when betterments constitute a legitimate 
capital expenditure and when they should be met out of earn- 
ings, is naturally always debatable. Conservative management 
tends strongly to decide the question in favor of the second 
alternative. When it is not so decided, there is always a 
danger at least of investing fresh capital in a form that will 
bring little if any returns. The statement is so obvious that no 
illustration is needed to enforce it. Its importance, however, 
should not be overlooked. In connection with the subject of 
distribution of income, the question as to the proper financing 
of betterments will be discussed at greater length. 



372 INTERNAL FINANCIAL MANAGEMENT 

Investing Capital in Side Lines 

As has been remarked, the managers of a corporation that 
has proved successful are seldom willing to stop. They wish 
to go ahead and enlarge their profits. This statement applies 
notably to the business men of the United States. In England 
and other countries business customs favor building up a sound 
business and maintaining it rather than restlessly pushing into 
other fields. No doubt the American practice makes for pro- 
gressiveness, yet it also involves a constantly recurring danger 
of disaster. 

The number of companies which have taken on "side line" 
enterprises to their sorrow is far beyond what would usually 
be supposed. A conspicuous example is the American Loco- 
motive Company which some years ago decided to engage in 
the business of manufacturing automobiles. The plant was 
poorly located and it is to be presumed that the officers had 
neither the time nor the special training which would have 
enabled them to handle this business with success. In 191 3 
internal dissension in the company brought to light the fact 
that over $2,300,000 had been lost during that year in the 
automobile enterprise. Subsequently the directors decided to 
accept their loss, dispose of the plant and other assets, and close 
all their activities in this field. 

In 1 9 14 the American Water Works Guarantee Company 
became financially embarrassed. This company had been a 
highly successful promoter of public utility corporations and 
of holding companies operating in the public utility field. 
After having succeeded in this line, it attempted to carry out 
certain irrigation projects and invested in these projects more 
than $10,000,000. In addition it eventually became necessary 
for the company to indorse more than $23,000,000 of the 
obligations of its irrigation subsidiaries. The result was that 
this "side line" became the most important activity of the 
company and was the direct cause of its embarrassment. 



INVESTMENT OF CAPITAL FUNDS 373 

On the other hand, it is sometimes true that a "side line" 
may prove to be the only really profitable feature of a business. 
For example, the London Underground Electric Railways 
Company shows investments of a nominal value of £17,000,- 
000, of which £15,500,000 is in the various underground 
railway companies, and £1,500,000 is in the London General 
Omnibus Company. The profits from the underground rail- 
ways were a trifle over 1%, or about £160,800; the profits 
from the omnibus service were nearly 23%, or approximately 
£377,000. 

Some of the great meat-packing concerns such as Armour, 
Swift, and Morris, started a great many years ago to operate 
refrigerator cars primarily for transporting their own products. 
As a "side line" they began to run these cars for the benefit 
of producers of fruit and vegetables, with the result, as is well 
known, that operating car lines became, in time, one of the 
most profitable features of their business. 

In the same way the United Fruit Company was originally 
designed merely to market tropical fruits, especially bananas. 
In the course of time, however, the company has taken over 
one "side line" after another until at present it conducts banana 
plantations, sugar plantations, railroads, tramways, steamships, 
and refrigerator car lines. It is understood that each of these 
developments has proved a profit-maker and that the company's 
revenue from its transportation interests is almost as great as 
from its original field of operation. 

The United Cigar Stores Company is said to have de- 
veloped successful "side lines," but has followed the policy 
of selling these lines after they were developed to separately 
organized and managed corporations. The profit-sharing 
coupons of the company have, for example, been taken over 
by the United Profit Sharing Corporation and the sale of 
chewing gum has been taken over by the Sterling Gum Com- 
pany. 



374 INTERNAL FINANCIAL MANAGEMENT 

Perhaps the most definite conclusion that can be reached 
here is that the creation of "side lines" is a dangerous business 
policy. It involves a diversion of capital, of thought, and of 
creative energy that would otherwise go into building up the 
company's own business. This is especially the case when a 
"side line" is taken on that has no vital or necessary connection 
with the original and proper business of the company. In that 
case, it calls for an especially heavy drain on the talent and 
resources of the company. The "side line" that develops 
naturally and almost unavoidably is of a different type. It 
may be considered as rather in the nature of an extension than 
a "side line." 

Even when a "side line" is successful, the question still 
remains whether the application of an equal amount of capital 
and of managerial ability to the company's own product would 
not have brought still greater success. Certain it is that those 
companies which have achieved the greatest records of growth 
are those which, like the Ford Motor Company, the National 
Cash Register Company, the Curtis Publishing Company, and 
thousands of others, have devoted themselves exclusively to 
turning out one or two cognate products and have never al- 
lowed money or energy to be diverted from this main purpose. 

Investing Capital in Securities 

Under this head we have to consider not the questions that 
arise in connection with the establishment or purchase of 
partly subsidiary enterprises, but those that arise in connection 
with using the surplus funds of a corporation partly for in- 
vestment in the securities of non-related corporations. We 
shall see in a succeeding chapter, in discussing methods of util- 
izing surplus funds, that some corporations make it a practice 
to place a portion of these funds in salable securities. How- 
ever, this is seldom carried to the extent of tying up in these 
investments a large proportion of the company's available 



INVESTMENT OF CAPITAL FUNDS 



375 



capital. The policy to be considered here is that which involves 
transforming a company from an active transportation, public 
utility, industrial, or trading enterprise into a company that 
has for one of its main functions investment of capital in 
securities. 

It is seldom that this transformation is effected through the 
desire or even with the consent of the great body of stock- 
holders. It is much more commonly the case that the active 
officers or directors of the company have private motives of 
their own for desiring to make use of the company's credit 
and other resources. The results achieved may conceivably 
in the long run be beneficial to the stockholders, but they do 
not affect the underlying motive. 

This appears to have been the situation with the Union 
Pacific Railroad Company at the time when it was under the 
domination of the late Mr. E. H. Harriman. Mr. Harriman's 
first efforts were directed toward making the Union Pacific an 
efficient and profitable railroad property. Having succeeded — 
or being well on the way toward success — in these efforts, his 
personal ambitions led him to invest the surplus profits of the 
Union Pacific more and more heavily in other railroad com- 
panies and to utilize the credit of the Union Pacific in raising 
great sums of money for the purpose of consolidating and 
extending these investments in other railroad properties. 
Thus, in the course of time the Union Pacific became half a 
railroad company and half an investment company. The 
decision of the Supreme Court of the United States in 1912, 
which compelled the Union Pacific to part with its holdings 
of the securities of certain other railroad companies, has in 
part remedied but has not completely changed this state of 
affairs. 

The Adams Express Company has total assets of approxi- 
mately $70,000,000, out of which "securities and investments" 
comprise $57,000,000. Its total earnings from investments 



376 INTERNAL FINANCIAL MANAGEMENT 

average 25 to 50% higher than its earnings from its own 
operations. 

On October 23, 19 14, announcement was made of the 
appointment of a receiver for the Toledo, St. Louis and West- 
ern (Clover Leaf) Railroad. Undoubtedly the prime reason 
for the failure was the investment of $11,500,000, in 1907, 
in common and preferred shares of the Chicago and Alton 
Railroad Company. The dividend record on the acquired 
shares was as follows : 





Common 


Preferred 


1907 




4% 


1908 


1% 


4% 


1909 


4% 


4% 


1910 


2% 


4% 


1911 




2% 


1912 






No dividends since. 







When in 1906 Mr. E. H. Harriman was questioned by the 
Interstate Commerce Commission as to the status of the Alton 
Railroad, he replied quickly, "You will have to ask the Rock 
Island people; they are carrying the bag." The following 
year the Rock Island succeeded in unloading on the Clover 
Leaf. The loss to the Rock Island on this transaction, how- 
ever, was heavy. It has been estimated at approximately 
$5,000,000. 

Another painful experience in making investments fell to 
the lot of the Rock Island Company. In 1902 Rock Island 
purchased Frisco common stock to the par value of $28,930,- 
300, giving in payment $60 per share in 5% bonds and $60 in 
common stock. Seven years later the Rock Island manage- 
ment sold the Frisco stock back to the original vendors at 
$37.50 per share, or $10,848,250. But before the stock could 
be transferred, it was necessary to pay the collateral trust 



INVESTMENT OF CAPITAL FUNDS 



377 



bonds, which were callable at 102^ and interest. To pay off 
these bonds required $18,160,037 cash, which was $7,311,175 
more than was received from the sale of the Frisco stock. 
To raise this additional cash, $7,500,000 of debenture bonds 
were issued. During the seven years the Rock Island owned 
the Frisco stock, it paid out in interest on the Frisco collateral 
trust bonds $6,077,000, and did not receive a cent of dividends 
on its holdings of Frisco stock. The actual money loss to the 
Rock Island Company was, therefore, $13,388,175. In ad- 
dition, the Rock Island Company has outstanding $17,364,180 
of its own stock, which was issued in part consideration for 
the Frisco stock. 

In studying the records of large corporations which have 
made investments on a great scale, one is more and more 
impressed with the idea that the men at the head of these 
corporations seem at times to lose their judgment in the 
handling of the enormous credit power that is under their 
control. They are apt to imagine that ordinary rules of sound 
judgment and careful figuring do not apply to them. They 
are in somewhat the same state of mind as the large clothing 
manufacturer to whom it was demonstrated that a big per- 
centage of his product was being sold below cost, "Oh, that 
will come out all right,'' airily replied the manufacturer. "You 
overlook the great scale upon which our operations are carried 
on." 

Another factor which makes for recklessness is the aston- 
ishing ease with which large corporations can issue stocks and 
bonds in exchange for property. It is apparently so simple 
and so tempting a thing to do — to have a few more pieces of 
paper engraved and given in exchange for railroads, factories, 
and control over the labor of thousands of men — that it requires 
a level head to keep clearly in mind that these new pieces of 
paper are so many additional obligations which sooner or 
later must be met. 



378 INTERNAL FINANCIAL MANAGEMENT 

Relative Amounts of Fixed and Working Capital 

This chapter has been devoted, in part, to emphasizing the 
necessity for providing adequate working capital. The result 
may be to restrict the investment in fixed forms and thus 
to limit the output and profit-making possibilities of the busi- 
ness. Such a policy would insure a degree of safety, even 
in the presence of emergencies, which comes only from the 
possession of an adequate working capital. The popular im- 
pression seems to be that it is absolutely essential for a corpor- 
ation to possess fixed assets which will enable it to turn out 
its product, whatever that product may be, and that whatever 
sum is left over will necessarily have to serve as working 
capital. There is probably no more dangerous fallacy in the 
whole range of business thought and action. The fact of the 
case is that, for most corporations adequate working capital 
is essential, while adequate fixed capital becomes desirable 
and necessary only after the success of the business has been 
fully demonstrated. This last statement is not intended to 
apply, of course, to those lines of business, particularly trans- 
portation and public utilities, in which working capital is 
not a requisite. 

To make the case concrete, let us suppose that a water 
power company is working out a fully completed project for 
installing a power plant and for serving manufacturing and 
public utility enterprises throughout a given district. We will 
assume that contracts for delivery of all the power that can be 
produced have already been assured and that the payments 
on these contracts are to be made monthly in advance. Under 
these conditions, we have an instance of a corporation which 
must have an amount of fixed capital that can be closely esti- 
mated in advance, and which must be sufficient to enable it to 
complete its whole installation. It needs no working capital, 
for the monthly cash receipts will be more than sufficient to 
meet its monthly outgo. 



INVESTMENT OF CAPITAL FUNDS 



379 



But let us take, also, the very common case of a corporation 
which is designed to produce and sell a patented device. Fre- 
quently the first step is to raise whatever fixed capital is 
required in order to build a plant and install equipment. Even 
though the company may have sufficient working capital, it 
is more than likely to find out a little later that the device 
itself, or the methods by which it is made, are not in their 
final form and much of the fixed capital will be wasted. 

A far more sensible procedure in most cases would be to 
have the device manufactured during the first year or two by 
some company which will take over the manufacturing con- 
tract, and to devote all the available capital to building up a 
selling plan and selling organization, to financing sales, to 
establishing the credit of the new corporation, and to installing 
whatever mechanical or business improvements are called for. 
That is to say, all the resources at the beginning should be 
kept in the form of working capital. After the selling problem 
has been solved and the final form of the product has been 
determined, it will be time enough to proceed with the erection 
of a plant. If this procedure were more generally followed, 
there would be fewer setbacks and failures in business. 

A closely related fallacy is the common idea that "more 
capital" is needed in order to make a business move ahead 
successfully, whereas the real need, ordinarily, is for a better 
use of the capital already available, and for a demonstration 
on a small scale that the enterprise can be made a profit-maker. 
After that demonstration has been given, it is usually compara- 
tively easy to raise fresh capital. 



CHAPTER XVII 

CALCULATING REQUIREMENTS FOR WORKING 
CAPITAL 

Factors to Be Considered 

In the preceding chapter the necessity for adequate work- 
ing capital in most lines of business has been emphasized. The 
question as to what is to be considered "adequate" in any given 
case, however, has been left open. It would be too much to 
expect that this chapter should present an exact arithmetical 
answer, or even a formula for arriving at the answer. There 
are too many variable factors to be considered. We can, how- 
ever, list and discuss the most important of these factors, and 
perhaps in this way throw a little additional light on one of 
the most difficult and most vital problems in the field of busi- 
ness financing. 

Following are the factors which require chief consideration 
when the amount of working capital required by a given enter- 
prise is to be calculated : 

1. Length of period of manufacture. 

2. Turnover. 

3. Terms of purchase. 

4. Terms of sale. 

5. Facilities for converting current assets into cash. 

6. Seasonal variations in the business. 

It may be well to repeat at this point the definition of 
working capital as "excess of current assets over current lia- 
bilities." In transportation and other enterprises which do 
not carry any excess of assets over liabilities, there is no 
working capital; in manufacturing enterprises it, is generally 

380 



REQUIREMENTS FOR WORKING CAPITAL 3 g T 

considered that the proportion of assets to liabilities should 
not be lower than ioo to 75, or 100 to 80. Sometimes the 
same ratio is expressed in the reverse order, and it is stated 
in mortgage indentures that current assets shall never be less 
than 133 1/3% or 125% of current liabilities. These ratios 
are not in themselves fixed and final standards. It would be 
far better to determine the amount of working capital in some 
more definite manner; if the amount is sufficient, we may be 
certain that the ratio of current liabilities to current assets 
will always be well within the limits of safety. 

Length of Period of Manufacture 

A company turning out a product which requires a long 
period of manufacture will be compelled to purchase raw mate- 
rials, pay for labor and other expenses incident to manufacture, 
and wait for a long period before the finished product is ready 
to sell. Large amounts of capital will necessarily be tied up in 
the process of manufacture itself. As an extreme instance, 
take shipbuilding. To build and equip a large vessel may 
require three or four years. The outlay may amount to several 
millions of dollars. In case the product is not paid for until 
delivery, and in case several vessels are under construction at 
the same time, it is clear that the amount of capital invested 
in raw materials, partly finished products, and other forms 
of working assets will soon become enormous. Like remarks 
apply to the erection of large buildings or other important 
pieces of construction which may require several years' time 
and the investment of millions of dollars before the product 
is completed. 

In these extreme instances, the problem is solved by throw- 
ing a large part of the burden of providing the expenses of 
construction upon the purchaser. Contracts for construction 
of all kinds almost invariably provide for inspection and ac- 
ceptance of the work that has been completed up to given stages 



382 INTERNAL FINANCIAL MANAGEMENT 

or at given intervals, and for payment on account by the pur- 
chaser of a proportionate share of the contract price. This 
arrangement is customary even with comparatively small pieces 
of construction, such as the installation of bank vaults, the 
erection of small dwellings, and the like. 

Even with this proviso, it is usually the case that con- 
struction and contracting firms are called upon to lay out large 
sums and to wait for a considerable period before they are 
reimbursed, and it is quite necessary, therefore, that their 
working capital should be correspondingly ample. There is 
scarcely any line of business in which insolvencies are more 
frequent than in contracting. The explanation is nearly al- 
ways the same; the working capital of the contracting firm 
is not sufficient to "swing" its undertakings. This is a diffi- 
culty which is peculiarly apt to confront all enterprising, 
progressive, and otherwise successful contractors. 

In the extreme instances that have just been cited, the 
necessity of securing either an exceptionally large working 
capital or a series of payments on account in advance of de- 
livery of the finished product, is universally recognized. But 
there are many less extreme cases in which the importance of 
this factor seems easily to be overlooked. In many processes 
of manufacture, time is one of the important elements. This 
is true particularly in handling "green" products such as lumber 
and hides; in making wines and distilling liquors of good 
quality; in developing suburban real estate; and so on indefi- 
nitely. The moment an effort is made to rush the process of 
turning out a finished product in any of these lines, the result 
is either a great increase in expense or an impairment in 
quality. On the other hand, it must not be forgotten that in 
slow processes provision for relatively large sums of working 
capital must be made. And in most cases it is not practicable 
to secure payment from the purchaser in advance of delivery 
of the finished product. 



REQUIREMENTS FOR WORKING CAPITAL ^ 

Moreover, there is a danger connected with long-process 
manufacturing, not on contract but for the general market, 
that fluctuations in prices may diminish or wipe out expected 
profits. To take care of such fluctuations and to carry the 
company through periods of distress which may result, it is 
essential both that the average profits should be high and that 
the supply of working capital should be ample. 

This w r as one of the main sources of trouble for the United 
States Leather Company when the combination was first 
formed; between the date of purchase of green "packer" hides 
in this country and the actual sale of the finished leather, from 
six to twelve months usually elapsed. Between the purchase 
of Argentine hides and the sale to a foreign consumer, this 
period may be extended to a year and a half or more. At a 
time of falling prices, the price of hides lags behind that of 
leather. As a result, in the middle cjo's, the United States 
Leather Company repeatedly sold leather for less than its cost 
of production.* 

Still another handicap to a business in which the period of 
manufacture is lengthy, is the impossibility of making quick 
adjustments to market conditions. By way of contrast, con- 
sider the case of a company at the other end of the scale — a 
bread-baking company, which manufactures overnight the 
product that it sells the next morning. If there were to take 
place a sudden shifting of demand from one kind of bread 
to another, or even away from bread altogether toward some 
other kind of food, the bakers obviously could adjust them- 
selves to the change in short order. The leather manufacturer 
has no such advantage. He is continually tied up with enor- 
mous quantities of hides and of leather in the various stages of 
manufacture. It is at least expensive, and in many cases 
impossible, for him to shift from one kind of product to an- 
other. He may suffer — and in fact many leather manufac- 



h Dewing's "Corporate Promotions and Reorganizations, 



384 INTERNAL FINANCIAL MANAGEMENT 

turers have suffered — severe losses due simply to changes in 
taste on the part of the consuming public. 

It is clear that the length of period of manufacture is an 
important factor in determining how much v/orking capital a 
corporation will need. A breadmaker does not risk as much 
in proportion to the volume of his business as does the leather 
manufacturer; for he has scarcely paid for his flour and labor 
before the receipts from his sales flow back to him. 

One important improvement in automobile manufacturing 
which within recent years has put it on a safer and more 
stable basis, is the reduction in the length of time required for 
turning out finished cars. 

Turnover 

A closely related factor is the rapidity of turnover of 
working capital. Although the word "turnover" has come to 
be highly popular, there is a remarkable absence of clear-cut, 
authoritative definition. Observation of customary usage, how- 
ever, makes it plain that its meaning in the minds of merchants 
and manufacturers is always the same. "Turnover" may be 
defined as the ratio of annual gross sales to average working 
assets. It is the figure, in other words, which shows how 
many times the amount invested in working assets has been 
traded in or "turned over" during a year. Note that the 
relation is between gross sales and working assets, not between 
gross sales and working capital. There would be some ad- 
vantage in basing figures on the second relation, but it is not 
customary to do so and it seems advisable to fall into line 
with customary business practice. 

We hear a great deal about turnover in trading operations, 
particularly in retail merchandising, and comparatively little 
about it in manufacturing operations. It is, to be sure, rela- 
tively of greater importance to the merchandiser than to the 
manufacturer, but it is by no means unimportant to the latter. 



REQUIREMENTS FOR WORKING CAPITAL 385 

As has previously been remarked, almost all the assets of a 
trading concern are working assets; the only capital invested 
in fixed assets is that which is given up to office furniture, 
store equipment, and the like. Both the wholesaler and retailer 
customarily buy on fairly liberal terms of credit and endeavor 
to sell the merchandise and make collections before their bills 
for the merchandise fall due. If they could always be sure of 
accomplishing this result, there would be no necessity for their 
possessing working capital; but, as we shall see in the next 
section, there is a strong tendency in this country toward short- 
ening the period during which merchandise bills run and there 
is also an ever-present uncertainty as to the retailer's ability to 
dispose of his products within any fixed period ; consequently, 
for both these reasons, he is called upon to provide a certain 
amount of working capital and often a very large amount. 
The manufacturer's proportion of working capital to fixed 
capital is much smaller than the trader's proportion. Never- 
theless, up to the extent of his investment in working capital, 
he is interested as well as the trader in turnover. 

It is clear that the greater the turnover, the larger the 
volume of business that can be conducted with a given work- 
ing capital. If a retail store, for instance, is handling a product 
for which there is a great demand and which can be sold 
almost as rapidly as it is stocked, the gross sales will be large 
and the investment in stock will be small. If sales, on the 
other hand, are irregular and slow, the amount of working 
capital invested in stock will necessarily be heavy. 

This is the first element in determining the rapidity of 
turnover. A daily newspaper stand will necessarily have a 
very rapid turnover, for the capital invested, plus the dealer's 
profit, will be realized in cash, at least once a day, and in the 
larger cities three or more times a day. The turnover for 
the newsdealer, under the above definition, is 500 to 700 
times per year. As soon as the newsdealer adds a stock of 



3 86 



INTERNAL FINANCIAL MANAGEMENT 



magazines and books, which sell more slowly, his turnover 
decreases. At the other end of the scale is a great jewelry 
store, such as Tiffany's, in which it is necessary to provide an 
immense stock of valuable goods from which the customer 
may choose, while at the same time the sales are compara- 
tively irregular and infrequent. Evidently the turnover in 
a business of this kind must be small. 

In addition to the timeliness of the merchandise that is 
carried for sale and the degree of standardization of the 
merchandise, which determines how much stock must be car- 
ried in order to give a satisfactory range of choice to the 
customer, another element that determines rapidity of turn- 
over is the sales policy of the merchandising firm. If the 
sales efforts are strongly directed toward disposing of a given 
stock of goods quickly — if necessary, making a sacrifice in 
price or incurring an extraordinary selling expense in order 
to achieve this result — the rate of turnover w T ill clearly be 
higher than in case there is no definite, clearly thought-out 
sales policy. Right here is the point at which the financing 
of great numbers of retail stores breaks down. If a pro- 
prietor fails to recognize the great importance of achieving 
volume of sales and rapidity of turnover, even though an inci- 
dental sacrifice of profits here and there may be involved, 
the result is that his shelves gradually become loaded with 
unsalable goods ; his receipts are not sufficient to meet promptly 
all his obligations for merchandise; his bills accumulate and 
his credit declines; and eventually he finds himself — usually 
to his own surprise— in a receivership or in bankruptcy. 

Precisely the same elements determine the rapidity of 
turnover in manufacturing concerns. The timeliness or im- 
mediate salability of the manufactured product determines 
whether he keeps his stock of raw materials, half-finished 
products, and finished products moving or whether it piles 
up on his hands. Second, by standardization of his product, 



REQUIREMENTS FOR WORKING CAPITAL 387 

accompanied by advertising which impresses the consumer 
with the superiority of the standardized product, the manu- 
facturer may cut down the number of his styles or varieties 
that he turns out. The automobile manufacturers have 
learned that one or two styles of chassis, each with two or 
three styles of body, is an ample line for any one manu- 
facturer. Those that have been most successful do not offer 
even this much of a choice. Thousands of manufacturers 
are still turning out a large variety of products to meet the 
tastes — often the whims — of customers, when it would be 
possible for them to standardize both the demand and their 
own output and thus increase to a wonderful extent the turn- 
over of their working assets. The third element — definite 
sales policy which endeavors to "clean up" accumulating 
stock — is almost as essential to the successful manufacturer 
as to the merchandiser. 

In determining the rapidity of turnover the manufacturer 
is more or less circumscribed by one element that does not 
affect the merchandiser, namely, the length of period of manu- 
facture. The merchandiser buys only finished products, and 
in order to attain a satisfactory turnover has only to stim- 
ulate the sales. The manufacturer, however, if his period 
of production is lengthy, will necessarily have a small ratio 
of turnover no matter what sales efforts he may put forth. 

It would be impossible to state definite figures for turnover 
in the various lines of business. In general retail store mer- 
chandising, the turnover has been known to go as high as 8 or 
10, but this is exceptional. Ordinarily 2, 3 or 4 — depending 
on the location of the store, the class of goods carried, and so 
on — would be regarded as a satisfactory turnover. 

Investigations carried on by the Bureau of Business Re- 
search of Harvard University show that the rate of turnover 
in retail shoe stores ranges from 1 up to 3.6. The turnover 
in a large number of these stores was found to be 1.8, and 



3 88 



INTERNAL FINANCIAL MANAGEMENT 



the Bureau considers a turnover of 2.5 as a realizable stan- 
dard in the average retail shoe store.* 

Terms of Purchase 

If an enterprise is paying cash for everything it buys and 
is selling on credit, it will obviously need a working capital 
sufficient to purchase outright its entire stock of goods, includ- 
ing everything that has been sold but not yet paid for. On the 
other hand, if the enterprise is able to buy on long credit and 
sell for cash, it can provide its whole stock with no immediate 
outlay and will pay its bills as they mature out of receipts 
from its own sales. Ordinarily, neither one of these extreme 
arrangements prevails. Goods are both bought and sold, at 
least in part, on a credit basis. 

The tendency within the United States, however, during 
the last two or three decades has been strongly toward reducing 
the length of credit available to purchasers of raw materials and 
of goods for resale. This reduction in the period of credit 
has been brought about, not by an apparent exercise of pres- 
sure, but by granting special "concessions" to those who were 
able to pay cash or to pay within 10 to 30 days. Gradually, 
as these concessions have come to be more and more accepted, 
the competition among retailers has made it more and more 
necessary that they should be accepted. Moreover, the in- 
creasing tendency in this direction has now made it the cus- 
tom in many lines of business to purchase for cash or on 
short time, and has therefore placed the sellers of merchan- 
dise in a position to insist upon prompt payment. 

In retail stores, for example, forty years ago it was not 
uncommon, nor was it considered improper, for a retail mer- 
chant to purchase a line of goods on six months , time. Some- 
times he was compelled to ask for further extensions. A 
little later some of the wholesalers who felt the need of more 



*Bulletin of the Bureau of Business Research, Harvard University, No. 1, May, 
1913, p. 14. 



REQUIREMENTS FOR WORKING CAPITAL 389 

available cash in their own business began to offer liberal dis- 
counts for payment within 30 to 60 or 90 days ; and well-to-do 
retail merchants gladly took advantage of these discounts. 
Other merchants, as will be more fully explained later on 
in this chapter, saw the advantage to themselves of borrow- 
ing from their local banks at fairly low rates of interest, thus 
securing funds with which they could take advantage of the 
discounts offered to them. After this custom became firmly 
established, the wholesalers began to expect prompt payment 
and, although the terms were still nominally three months 
to six months with a discount for anticipating payment, the 
wholesaler based his calculations on the cash price and the 
so-called "discount" came to be more and more in the nature 
of a penalty imposed upon those who failed to pay their bills 
within 10 to 30 days. So well understood is this custom 
at the present time, that a merchant who fails to take ad-r 
vantage of the cash discount offered to him is soon looked 
upon with suspicion. 

Any so-called discount which is far in excess of customary 
rates of interest is to be regarded as a penalty for non-payment 
of bills rather than as an incentive to prompt payment. A 
striking example is the custom among periodicals, of render- 
ing bills for advertising space nominally payable within 30 
days, but with a discount of 2 to 5% for payment within 
10 days. Inasmuch as these bills are customarily rendered 
before the issue containing the advertisement is actually ready 
for distribution, the publisher usually receives his payment 
in advance of any service that he has rendered to the adver- 
tiser. Doubtless the custom arose out of the danger that 
advertising space may be lightly ordered by concerns which 
have little real use for it or are unable to pay for it ; hence 
the publisher feels justified in practically demanding — through 
the medium of abnormal discount rates — that payment -be 
made in advance. 



3 9 o INTERNAL FINANCIAL MANAGEMENT 

In the "capital-poor" countries in which industry and trade 
are constantly tending to expand more rapidly than adequate 
capital for developing them can be obtained, the custom of 
granting long terms to purchasers for manufacture or re- 
sale, which formerly prevailed in this country, continues to 
exist. In Argentina, for example, it has during recent years 
been customary for importers and wholesalers of merchandise 
to sell to the general retailers in the farming districts on 90 
to 180 days' time and in addition make liberal provisions 
for renewal of the retailer's obligations. In turn, the re- 
tailer customarily sold goods to the farmers and others in 
his district on similar long terms. Frequently, the retailer 
was able to go a step further and actually make advances to 
his customers in order to enable them to carry on their farm- 
ing operations and harvest their crops. Each year as the 
crops were brought to the market and sold, the farmers were 
able to repay the merchants for all the advances and the 
goods they had received during the preceding several months, 
and the retail merchant was then in position to settle his 
obligations to the wholesaler, who in turn was able to 
clear up his obligations. Under this system the importer and 
wholesaler were "carried" in part by the manufacturers — 
chiefly in foreign countries — from whom they purchased ; 
the retailers were "carried" by the wholesale dealers; and 
the farmers and other consumers of goods were "carried" 
by the retail merchants. In years when the crops were good, 
the harvest months were a period of rejoicing and realiza- 
tion of good profits on the part of every one. When the 
crops were bad, the entire structure of mercantile credit was 
shaken and a large proportion of the weaker concerns inevi- 
tably went to the wall. 

In European countries the general custom prevails of ac- 
companying invoices for shipments of goods with drafts 
drawn on the purchaser usually for 30 or 60 days. After 



REQUIREMENTS FOR WORKING CAPITAL 



391 



receiving the goods and satisfying himself that they are in 
good condition, the purchaser "accepts" the draft which then 
becomes an obligation on his part of the same general char- 
acter as if he had given a promissory note. The "accepted" 
draft may be discounted by the house which sold the goods, 
at its own bank or may even be sold in the open market. 
At any rate, the seller of the goods quickly and easily col- 
lects payment, while the purchaser of the goods has an oppor- 
tunity to adjust his affairs, knowing that he will be called 
upon to meet his accepted draft on a given day. This sys- 
tem is claimed by many bankers to have noteworthy ad- 
vantages over the custom which prevails in the United States 
of persuading the retailer through the use of penalty dis- 
counts to pay cash for his purchases. 

The system prevailing in this country is made possible 
only by the existence of great numbers of local banks. The 
local merchant is in position to borrow from these banks and 
thus to take upon his own shoulders the whole burden of 
financing his purchases of goods, whereas in other countries 
the seller of the goods, either through his own resources or 
through his banking connections, attends to the financing 
of the transaction. The same custom has not as yet come 
to prevail when the manufacturers are the purchasers of 
goods. Ordinarily they buy on 30 to 90 days' time, or in 
case of special and exclusive contracts often on longer time. 
It is usual, however, when accounts run for longer than 
two to four months, for the purchaser to give in payment 
his promissory note which the seller may then discount at 
his own bank. The tendency is strong even here to reduce 
the period of credit and through the offer of discounts to 
bring pressure to bear for the prompt cash payment of 
accounts. Unless some contrary tendency should make it- 
self felt, we may reasonably expect, as time goes on, to see 
the burden of financing dealings in raw materials, as well 



392 INTERNAL FINANCIAL MANAGEMENT 

as in finished products, assumed to a greater and greater 
extent by the purchaser. 

The effect of this tendency on working capital is self- 
evident. When the purchases of a firm are made on long- 
term credits and money is collected from sales before the 
corresponding obligations fall due, working capital is re- 
quired only to take care of emergencies. But when the pur- 
chaser undertakes to pay cash, he must either possess so 
much working capital that he can make payment out of his 
own resources, or at least he must possess enough 'to provide 
a margin of safety which will enable him to borrow from 
banks without question and on favorable terms. The shorter 
the period of credit that is customarily used by a firm in 
making purchases, the larger must be the working capital 
of the firm. 

Terms of Sale 

Looking now at dealings in ; raw materials and merchan- 
dise from the seller's point of view, let us consider the effect 
upon working capital of the customary or average terms of 
sale. We shall give particular attention to two classes of 
transactions that were not treated in the preceding section, 
viz., sales to purchasers in foreign countries and sales by the 
retailer to the consumer. 

So far as dealings between producers and those who pur- 
chase for manufacture or resale are concerned, these deal- 
ings have been discussed at sufficient length in .the preceding 
pages. It is enough here to state the corollary of the con- 
clusion therein reached, viz., the longer the period of credit 
which it is necessary to extend in effecting sales, the larger 
must be the amount of working capital. 

There are some special considerations, however, that mod- 
ify this conclusion in its application to financing sales in for- 
eign countries. These special considerations arise out of the 



REQUIREMENTS" FOR WORKING CAPITAL 39-3 

fact that the methods of financing these foreign sales differ 
somewhat from the method of financing a domestic sale. 
First of all, the domestic sale is usually on open account; 
hence, the seller does not come into possession of a piece of 
commercial paper which he can readily discount. When 
the terms of credit are longer than two to four months, as 
has been noted above, the principal may give his promissory 
note, but it is not the customary type of transaction in this 
country. In foreign trade, however, the European custom is 
followed of accompanying the shipments of goods with a draft 
drawn upon the purchaser. In the South American trade 
this draft is usually due for payment 90 days after the goods 
have arrived at their destination; on arrival of the goods it 
is expected that the purchaser will promptly inspect them 
and, if they are in accordance with his order, will "accept" 
the draft which in the meantime will have been forwarded 
to one of his local banks. Inasmuch as it requires at least 
a month, or usually more on an average, to secure delivery 
of shipments from this country to South American countries, 
and another month is required before funds paid at a South 
American city can be transferred by mail to a city within 
the United States, there is an interval of at least five months 
to be bridged over between the date of shipment and the 
date of receiving payment — one month for the shipment and 
draft to reach destination, three months until maturity of 
the draft, and one month thereafter until payment reaches 
the shipper in the United States. It should be borne in mind, 
also, that five months is almost the minimum period. In 
case it is desirable or necessary to renew the draft, or in case 
communication requires more than one month, the period 
before final payment is received may drag out to six or nine 
months or even more. 

If a manufacturer is to build up export trade as an im- 
portant feature of his business, it is evident that he must either 



394 INTERNAL FINANCIAL MANAGEMENT 

provide a great addition to his working capital or he must 
have assistance of some kind in financing this export trade. 

In the countries which are the chief commercial competi- 
tors of the United States — England and Germany — systems of 
financing foreign sales are worked out in great detail; and 
this constitutes one of the most important advantages which 
these countries enjoy in competing with American manufac- 
turers in such markets as those of the Far East and South 
America. A like system is now in process of formation in 
this country. It is to be hoped that it will be completely 
worked out in time to enable American manufacturing ex- 
porters to get a firm hold on the trade in competitive markets 
during the present favorable conditions. 

Basically there are five possible methods under which the 
manufacturer who is making export shipments may quickly 
realize the cash value of his shipments : 

1. He may turn over the financing (with or without the 
selling) to a firm of commission merchants who agree to pay 
the manufacturer in cash and to charge a sufficiently higher 
price to the customer to compensate them for their special 
knowledge, advances of money, and risk. In some lines, and 
with the proviso that the right kind of contract is made with 
commission houses, this may prove to be a satisfactory method. 

2. The exporter may carry through his own sales, draw a 
draft in accordance with the usual custom to accompany the 
shipment, turn the draft — or bill of exchange as it is more 
commonly called — over to his local bank to send forward for 
collection, and on the strength of this increased business secure 
from his bank an enlarged line of credit. This is very much 
the same plan that would be followed if the manufacturer were 
to increase his domestic business. It is usually highly unsat- 
isfactory as a means of financing export shipments, however, 
because the banker is seldom willing to grant credit for a suffi- 
cient length of time, or to a large enough amount, to give the 



REQUIREMENTS FOR WORKING CAPITAL 395 

manufacturer all the assistance that he needs. In other words, 
under this plan it is necessary for the manufacturer largely 
to increase his working capital in order to handle export trade 
and this places him at a disadvantage as compared with his 
foreign competitors. 

3. The manufacturer may forward his bills of exchange 
for collection through his bank, and arrange with the bank to 
give him an advance up to a fixed percentage of each draft. 
This percentage may be as low as 50% or as high as 90%, 
or even 95%. This is certainly a better arrangement both 
for the manufacturer and for the banker, inasmuch as it gives 
the manufacturer a larger amount of available credit which 
varies in direct proportion to his foreign business, and gives 
the banker a direct collateral of good quality to secure his 
advances. Until recently it has been the method most widely 
used within the United States, and is also much used in 
England and Germany. The chief objection to it is that it 
does not go far enough, inasmuch as the percentage of safety 
which the American banker requires is much higher than the 
percentage customarily required in competitive countries. 

4. The exporter may actually "discount" or "sell" his bill 
of exchange, to a banker who is doing business through a 
branch or through a closely allied correspondent in the district 
to which the shipment is going. The bill is usually bought 
"with recourse," which means that the banker reserves the 
right to demand payment of the draft from the exporter in 
case the importer fails to meet it promptly. It is usually 
discounted at 6%, more or less, with an additional commis- 
sion charge of perhaps J^%. This is, on the whole, a sat- 
isfactory method of financing so far as the manufacturer is 
concerned. He gets his money, minus a reasonable discount 
and commission charge, at once, and thus is not stripped of 
working capital. To be sure, a contingent liability remains, 
but, unless his sales policy is defective in the extreme, there 



39^ 



INTERNAL FINANCIAL MANAGEMENT 



will be very few cases in which his bills go to protest. The 
chief objection is that the banks of the United States are not, 
as a rule, sufficiently well represented abroad to carry on this 
business, so that it is conducted chiefly by agencies of foreign 
banks in New York City. 

5. The exporter may turn over his bill to his bank to for- 
ward for collection, and the bank in turn may permit the 
exporter to draw another draft on the bank, which the bank 
"accepts." The exporter may then take this "accepted" draft 
into the open market and sell it for whatever it will bring. In- 
asmuch as an accepted draft is practically equivalent to a 
promissory note, those drafts which have been accepted by 
strong banks, are salable at a very low discount rate. The 
bank charges a small commission, equivalent to about 1 to 2% 
per annum, for stamping its acceptance on a draft. Usually 
the draft drawn on a bank is for 80 to 95% of the amount of 
the exporter's draft on his customer* This method has been 
possible in the United States only since the Federal Reserve 
Act went into effect in November, 19 14^ It is simple and 
practical and gives to most exporters the financial assistance 
that they require. Usually the manufacturer is able, through 
this method, to get returned at once at least the full amount 
of the cost to him of manufacturing and selling the goods 
he is shipping, and is compelled to wait only for his profit on 
the transaction. That being the case, he may carry on as 
much export trade as can be financed in this way without 
direct increase in his working capital. 

As was remarked in the preceding section, the English 
custom is to accompany almost all shipments, domestic as well 
as foreign, with drafts, which are accepted by the purchasing 
house and thereupon become a good quality of marketable 
paper which banks are quite ready to discount. This system 
enables the manufacturer to borrow large amounts from his 
banks with safety, and to count upon this borrowing as a 



REQUIREMENTS FOR WORKING CAPITAL ?>97 

permanent source of funds not subject to the more or less 
arbitrary conditions that bankers find it necessary to impose 
under the American system. The English manufacturers and 
trades, therefore, are in position to carry on their business 
with a much smaller amount of working capital than is re- 
quired by a business of corresponding volume in this country. 
Take an example at random : The well-known English firm 
of Bolckow and Vaughan, manufacturers of iron and steel, car- 
ried on a recent balance sheet current assets as follows : 

Sundry Debtors (Accounts Receivable) £224,000 

Stocks (Inventories) 750,000 

Cash 39,000 

Total £1,013,000 

The Sundry Creditors (Accounts Payable) were listed at 
£500,000. 

Note the remarkably small amount of cash in proportion 
to the current assets and liabilities. The fact that so large 
and prosperous a firm should carry so little cash can be ac- 
counted for only as a result of the English practice with 
regard to financing sales which has just been alluded to. 
Under this practice it is easy for the manufacturer or trader 
to realize on his sales and secure whatever cash he needs on 
short notice. 

For this reason it is important that better facilities should 
be developed in the United States for financing sales abroad 
and long-term sales within this country. If this were done, and 
probably it will be done, the amount of working capital re- 
quired to handle a given volume of business would be much 
reduced. For the time being, however, and until these facili- 
ties are more fully and more efficiently supplied, we must in 
many cases figure that any increase in sales which is accom- 
panied by a lengthening of the terms of payment will neces- 
sarily involve a disproportionate addition to working capital. 



398 



INTERNAL FINANCIAL MANAGEMENT 



Financing Instalment Sales 

Another highly important departure in American business 
practice which involves difficulties of financing and calls for 
some special consideration, is the growth in the custom of 
making retail sales of high-priced goods, payments for which 
are deferred and are made in instalments. This is a practice 
which already has a wide application and which gives promise 
of spreading. Originally, "selling on the instalment plan" was 
confined largely to high-priced sets of books and a few other 
articles of luxury. At the present time, however, it is the 
customary plan of sale in such widely separated lines as pianos, 
suburban real estate, agricultural machinery, courses of in- 
struction, and sewing machines. It is being introduced more 
and more also in selling clothing, furniture, jewelry, motor 
cycles, automobiles, and many other articles. 

There has been much opposition to this wide-spread use 
of the instalment plan, on the ground that it leads thousands 
of imprudent people into buying articles that they do not need 
and incurring debts which easily grow to be a serious burden. 
In so far as the instalment plan is used in selling articles of 
luxury that do not in any way add to the efficiency or the 
earning power of the buyer, this objection seems to be well 
founded. It is equally clear, however, that the objection does 
not apply when the article that is sold tends to increase earn- 
ing power; for in that case the purchaser is simply making 
use of his credit, just as every business house should do, in 
order to enlarge his facilities for carrying on his activities as 
profitably as possible. He is following the same policy that 
the railroad follows when it purchases rolling stock on the 
instalment plan and gives its equipment notes in payment. 

However, we need not here enter into any discussion of the 
social aspects of instalment selling. The only point that really 
concerns us is the financial problem that confronts the manu- 
facturer or retailer who adopts the instalment plan. Fre- 



REQUIREMENTS FOR WORKING CAPITAL 399 

quently it has been adopted without the slightest realization, 
apparently, that any financial problem accompanies it. As a 
result, hundreds — or more likely thousands — of instalment 
houses in various lines of business have been wound up in 
bankruptcy proceedings and the whole method, no matter how 
it may be applied, has come to be looked upon by bankers with 
much distrust. Here, again, some discrimination should be 
used. 

The financial difficulty arises out of the simple fact that 
the whole cost of the product that is being sold, plus the cost 
of selling and of overhead administration, is paid out before 
the product is delivered to the customer, whereas payment is 
received only in small periodic amounts extending usually over 
several months. In disposing of real estate on the instalment 
plan, it is not uncommon for payments to be spread over five 
to ten years or even longer. In selling pianos the payments 
frequently spread over as long as three years ; in selling furni- 
ture, agricultural machinery, and the like, the term of pay- 
ment is customarily about one year. 

A secondary financial difficulty arises out of the fact that 
a certain proportion of the sales will be made to people who 
cannot, or will not, live up to their contracts. The manufac- 
turer or retailer may then proceed to take back his goods, but 
they will usually be in a damaged condition. In any case the 
expense of making and handling the sale and of attempting 
to collect the instalment payment will have been incurred and 
cannot be recovered. The expenses and losses of collection 
together constitute an item that must be carefully calculated 
and taken into consideration in every instalment business. 

The simplest and one of the most common forms of instal- 
ment contract is an agreement on the part of the purchaser 
to pay the fixed price of the article he acquires at the periods 
and in the amounts agreed upon, in return for which the 
purchaser obtains full possession of and title to the goods. 



4oo 



INTERNAL FINANCIAL MANAGEMENT 



The seller under this agreement has practically nothing ex- 
cept an "open account'' against the purchaser. He depends 
largely upon the purchaser's good faith and on the average 
honesty of the people he is dealing with, which is usually high. 
It is this last element — the average honesty of his customers — 
which constitutes the seller's chief protection and chief asset. 
He may, of course, be able to enforce collection by legal 
process, and will probably make it his policy to do so when- 
ever a purchaser gives evidence of acting in bad faith; but, 
if he were compelled to make any large proportion of his col- 
lections by legal process, he would be out of business in a 
short time. In spite of its apparent looseness and the heavy 
risk which the owner of merchandise appears to take whenever 
he parts with it on such terms, instalment houses that are 
selling a really meritorious product by proper methods to a 
good class of people find that they can count with perfect 
safety on only a small proportion of expenses and losses in 
making collections. 

Where the amount involved in each sale, however, is large, 
or where it is desirable to reserve as full protection as possible 
for the selling house in order to satisfy bankers' ideas, two 
variations — both designed for the protection of the seller — ■■ 
may be introduced. One of these variations consists of retain- 
ing title to the property in the hands of the seller until after 
the agreed price has been paid in full. This is the arrange- 
ment when equipment is sold to railroad companies. It is 
customary in selling pianos, furniture, real estate, and many 
other high-priced articles. The legal interpretation of what 
is commonly known as a "lease contract," under which the 
instalment payments are technically regarded as rental until 
after the final instalment has been paid, when title passes to 
the purchaser, varies from one jurisdiction to another. In 
some states it has been held to be practically the equivalent 
of a sale and the title is regarded as having passed to the 



REQUIREMENTS FOR WORKING CAPITAL 4 oi 

purchaser at the beginning of the transaction. In most juris- 
dictions, however, the lease form of contract is upheld. Much 
indignation has been aroused — some of it doubtless justified 
— at the attitude of some dealers who have sold furniture 
under lease contracts and at the first sign of default have taken 
back the furniture and at the same time retained all the pay- 
ments that have been made by the purchaser. There often 
seems to be injustice in such procedure; and yet the seller 
may usually claim with truth that he is actually the chief loser 
in every such case and it is necessary for him to take drastic 
action in order to protect himself against fraud. 

The second variation is that of requiring the purchaser to 
give a series of notes covering his instalment payments. This 
puts the transaction into a much more definite, irrevocable 
form, and also assists the seller, as we shall see presently, 
in making his financial arrangements. Where the amount is 
large — say several hundred dollars or more — it is almost al- 
ways wise to require the purchaser to give a series of notes. 
Where the amount of the transaction is small, the difficulty of 
getting the notes and the annoyance which the customer feels 
in giving a note for a small amount are drawbacks which are 
not compensated for by any general increase in the seller's 
safety. It does not pay to sue for payment of notes of small 
denomination. Except for a shadowy moral influence, there- 
fore, the instalment seller is not materially better off for hav- 
ing the small notes in his possession than when he simply has 
on his books an open account against the purchaser,, 

Working Capital Requirements for Instalment Selling 

Coming back now to the financial problem of carrying on 
an instalment business, let us take the hypothetical case of a 
product which sells at a retail price of $100. We will say 
that the cost to the manufacturer or retailer is $60, the selling 
expense is $20, and the overhead charges, including collection 



402 



INTERNAL FINANCIAL MANAGEMENT 



expense and loss, are $10, leaving net profits of $10. We 
will assume that the firm which sells this product disposes of 
50 of the articles during the first month of operations; ico 
the second month ; 150 the third month ; 200 the fourth month ; 
and thereafter regularly sells 200 each month. We will as- 
sume, further, that instalment payments are made at the rate 
of $10 per month. In order to simplify the problem, we will 
make the arbitrary assumption that the whole $90 outgo, 
including collection expense and loss, is incurred at the time 
each sale is made. Under these assumed conditions, how 
much working capital will be required to "swing" the stated 
volume of business ? During the first month the outgo would 
be 50 times $90, or $4,500 and the cash receipts would be 50 
times $10, or $500, leaving a cash deficiency of $4,000. During 
the second month the outgo would be 100 times $90, or $9,000, 
while the receipts would be $500 covering sales made during 
the first month, plus $1,000 for sales during the second month, 
making a total of $1,500; leaving a cash deficiency of $7,500. 
Putting these and succeeding calculations into tabular form, 
they would be as follows : 











Cash Deficiency 


Accumulating 






Outgo 


Receipts 


for Month 


Deficiency 


First 


month 


$4,500 


$500 


$4,000 


$4,000 


Second 


it 


9,000 


1,500 


7,500 


11,500 


Third 


it 


13^00 


3,000 


10,500 


22,000 


Fourth 


a 


l8,000 


5,000 


13,000 


35,000 


Fifth 


tt 


l8,000 


7,000 


11,000 


46,000 


Sixth 


i( 


l8,000 


9,000 


9,000 


55,ooo 


Seventh 


" 


l8,000 


11,000 


7,000 


62,000 


Eighth 


a 


l8,000 


13,000 


5,000 


67,000 


Ninth 


a 


l8,000 


15,000 


3,000 


70,000 


Tenth 


a 


l8,000 


17,000 


1,000 


71,000 


Eleventh 


it 


l8,000 


18,500 


500* 


70,500 


Twelfth 


receipts. 


l8,000 


I9.500 


1,500* 


69,000 


*Excess 





REQUIREMENTS FOR WORKING CAPITAL 403 

It is clear from the above table that, in case the instalment 
seller intends to carry the whole burden of financing on his 
own shoulders, he must be prepared with a working capital 
amounting at a maximum to $71,000. Unless his business 
afterwards increases more rapidly than his cash receipts, he 
will be able later to draw large profits in cash which are the 
accumulated results of sales that he has made during the pre- 
ceding months. 

The case above given is necessarily crude, for within the 
space limits that can be assigned to the subject in this volume 
it would be impossible to enter into all the intricacies of the 
calculations that would be required in any actual case. The 
figures presented, however, serve to emphasize two principles 
which must be borne in mind in connection with all instalment 
financing : 

1. During a period of rapidly increasing business the cash 
receipts cannot keep pace with the volume of sales and the 
outgo. Such a period, therefore, necessarily involves a severe 
strain on the financial resources of the instalment house. It 
is for this reason that prosperity and large sales have so fre- 
quently been the direct causes of financial disaster to firms 
that sell goods on instalments. 

2. Inasmuch as cash receipts pile up much more slowly 
than sales, the first stage in building up an instalment business 
is a stage of heavy investment and of patient waiting. No 
matter what profits may be figured on the volume of business 
that is being done at this stage, it is evident that the realization 
of those profits in cash will necessarily be deferred to a later 
period. This preliminary stage may last for several years. 
After the business becomes fairly stationary, however, cash 
receipts from preceding sales begin to accumulate with rapidity 
and presently the financial position of the house becomes very 
strong. 

The question arising in connection with every instalment 



4 04 INTERNAL FINANCIAL MANAGEMENT 

business, therefore, is : what can be done to shift some of the 
financial burden of building up the business from its own 
shoulders to the shoulders of its bankers or of other financial 
agencies? Unless this problem can be satisfactorily solved, 
an instalment house must necessarily be limited in its growth 
by the capital that can be contributed by those directly in- 
terested in the company. The problem is made peculiarly 
difficult by the fact, to which allusion has previously been 
made, that bankers, as a rule, have not been favorably impressed 
by their dealings with instalment houses and are not inclined 
to look with much favor on propositions to aid in financing 
such enterprises. In fact it may be said that, so far as new 
enterprises which sell on the instalment plan are concerned, 
they cannot reasonably hope for financial assistance from 
banks until after their business has become well-established 
and has proved itself sound and profitable. 

Established instalment enterprises, which have a growing 
business and therefore require additional financing, are or- 
dinarily able to obtain the temporary advances of working 
capital that they need in one of three ways : 

1. By securing a large line of credit from their banks 

simply on the strength of their general showing 
of profits and their accumulating assets, consisting 
of instalment accounts receivable. 

2. By securing, as indicated above, notes from their 

purchasers. Those concerns which make their sales 
in units of considerable size are frequently able to 
discount these notes or to place them as collateral 
for bank loans and are thus able to finance their 
requirements. This is very largely done by firms 
which sell agricultural machinery. The chief 
financial strain upon them is largely in the nature 
of a seasonable strain and the financial help which 



REQUIREMENTS FOR WORKING CAPITAL 405 

they require, is, therefore, of a more temporary 
nature than is the help required by instalment 
houses the business of which is not greatly affected 
by the seasons. 
3. By making arrangements, not with a bank, but with 
a financing company, which will either purchase 
their instalment accounts or instalment notes re- 
ceivable, or will make advances against these 
accounts or notes which are put up as collateral. 

This last method brings us to the subject of converting 
assets into cash, which is treated in the next section. 

Converting Working Assets into Cash 

The distinction between ''quick" assets and "working" 
assets has already been noted (Chapter XVI). We can go 
a step farther and make a like distinction between cash and 
Other quick assets; under the latter classification are to be 
included accounts and notes receivable that mature within a 
few days and merchandise which is already sold or is readily 
salable for cash. The only asset that is acceptable in settling 
bills is cash, but other quick assets may be counted as almost 
equivalent to cash. 

Those current assets which are convertible into cash only 
after a considerable lapse of time or after considerable effort, 
belong in a different category. It is dangerous to count on 
them as if they were cash, for numerous contingencies may 
interfere with their being converted into ready cash at the 
time that has been anticipated. Many a merchant has found 
himself suddenly face to face with bankruptcy because he 
counted merchandise on his shelves as if it were already sold 
and later found it to be unsalable ; or because he looked upon 
accounts receivable on his books as if they were already col- 
lected and later found that some of his important customers 
were themselves embarrassed or were "slow pay." It is be- 



4o6 INTERNAL FINANCIAL MANAGEMENT 

cause these contingencies exist, that it is necessary in the 
prudent management of most business concerns to maintain 
current assets at an aggregate figure considerably exceeding 
current liabilities. In manufacturing concerns, as we have 
seen, the current assets are usually regarded as normal if they 
are 125 to 133% of current liabilities. 

The more readily the current assets of a corporation are 
convertible into cash, the less need be the proportion of current 
assets to current liabilities ; or, to state the same thing in other 
terms, the less need be the working capital of the concern. 
It is clear that if working assets consist exclusively of cash, 
all the requirements of safety would be met if these assets 
were equal to the current liabilities. In other words, a concern 
with perfectly liquid working assets, need have no working 
capital. The nearer a company approaches to this condition, 
the smaller is its requirement of working capital; conse- 
quently, it follows that any measures which can be taken to 
increase the liquidity of such assets as inventories and accounts 
receivable will make possible a corresponding saving in the 
sum that must be set aside for working capital. 

There is no method of increasing the liquidity of stocks 
of merchandise except care in manufacturing or in purchasing 
only stocks that are readily salable. No one outside the busi- 
ness itself can be of much assistance in securing this result. 
Accounts receivable, however, constitute an asset that can be 
transferred and, inasmuch as most of these accounts are auto- 
matically at some later date converted into cash they furnish 
an excellent collateral for preliminary advances of cash. 

Within recent years a large business has been built up by 
a number of financing corporations which make it their chief 
business to make advances against instalment accounts re- 
ceivable and commercial accounts receivable, thus enabling the 
firm which owns such accounts to convert them wholly or 
partially into cash before they have come to maturity. 



REQUIREMENTS FOR WORKING CAPITAL 407 

In European practice financing corporations of this type 
are unknown and unnecessary, for most sales of merchandise 
are represented by accepted drafts (more commonly known 
as "trade acceptances") which the selling firm may discount 
at its own bank or may sell in the open market. In the United 
States, however, the custom prevails of granting "lines of 
credit" at banks; these lines of credit are based in large part 
on the concerns' showing of a satisfactory proportion of work- 
ing assets to current liabilities and the bank does not favor 
any method of anticipating the normal conversion of current 
assets into cash or of pledging any of the current assets. It 
has, in fact, grown to be an accepted principle, which many 
bankers perhaps fail to apply with sufficient discretion, that 
all current assets must be kept free and unincumbered ; other- 
wise the bank will not care to extend credit. 

In spite of opposition on the part of the banks, the financ- 
ing corporations have rapidly increased the volume and raised 
the character of their dealings. Moreover, certain banks and 
trust companies have gradually come to carry on a limited 
amount of business of the same type. 

There are two distinct fields of operation for the financing 
corporations that have been referred to, and they are readily 
divisible into two corresponding groups : The first group con- 
fines itself almost entirely to making advances against instal- 
ment accounts receivable, and the second group into making 
advances against commercial accounts receivable. The chief 
kinds of instalment accounts handled in this manner are those 
which arise in connection with the sale of agricultural ma- 
chinery, pianos, and other musical instruments. Both these 
lines of business are conducted by large and well-established 
corporations which do a national business, in some instances 
making sales direct to consumers and in others making sales 
through dealers to whom they frequently give assistance in 
financing their business. For reasons that have been fully 



408 INTERNAL FINANCIAL MANAGEMENT 

explained above, the amount of capital that would be required 
to finance an instalment business of any size would be prohibi- 
tive to most retail dealers if they were to work unassisted. 
Publishing companies which sell dictionaries, encyclopedias, 
and other sets of books, payment for which is made by instal- 
ments, also frequently secure advances, using their accounts 
receivable as collateral; for various reasons, however, this 
class of instalment accounts is not ordinarily regarded with 
so much favor as the other classes that have been mentioned. 
As typical of the manner in which the financing corpora- 
tions that handle instalment accounts operate, we may take the 
published description issued by the Commercial Security Com- 
pany of New York and Chicago, which makes advances on 
the strength of notes, mortgages, and leases given by pur- 
chasers of pianos to dealers and manufacturers. The company 
deals only with concerns which furnish satisfactory financial 
statements and have a good commercial rating. This concern 
must guarantee all the instalment accounts, leases, or notes 
which are assigned to the Commercial Security Company as 
collateral. The accounts (which may be in the form of leases 
or of notes secured by mortgages) are not actually taken over 
by the Commercial Security Company, but are left in charge 
of some one in the employ of the dealer or the manufacturer 
who is authorized to make collections and who is bonded to 
make prompt payment of the proceeds to the Security Com- 
pany; the former custom of transferring the accounts bodily 
to the financing corporation which made its own collection has 
proved objectionable and has been almost entirely abandoned. 
The Commercial Security Company requires that final instal- 
ments on the paper which it accepts as collateral must mature 
within 31 months, and that at least 20% of the price of the 
piano must have been paid, leaving 80% of the price to be 
collected. Against this balance the Commercial Security Com- 
pany makes advances to the extent of 80% ; in other words, 



REQUIREMENTS FOR WORKING CAPITAL 409 

the maximum advances are equivalent to 64% of the retail 
price of the pianos. The Commercial Security Company then 
deposits the paper which it has accepted as collateral, with 
certain designated trust companies in New York and Chicago, 
and issues its own 6% bonds up to 80% of the face value of 
the paper which it has deposited. These bonds (which might 
better be called "serial notes") are issued in series of $100,000, 
$10,000 maturing every three months, so that each issue is 
paid out within 2^ years. The bonds are sold to banks and 
to the general public, and are said to be well regarded as a 
good type of short-terms notes. 

The Agricultural Credit Company, which was incorporated 
in New York in 19 12, operates along much the same lines, 
except that it specializes in the notes or other obligations given 
in payment for agricultural implements. A number of other 
companies might be mentioned. 

In making advances on commercial accounts receivable, 
the Manufacturers' Commercial Company of New York fol- 
lows much the same plan that has just been described. This 
company purchases the accounts receivable of mercantile firms 
and deposits the paper which it purchases with a trust com- 
pany as collateral for its own issues of collateral trust certifi- 
cates. These certificates bear 5% interest, maturing in from 
30 days to one year and are in amounts of $100 or any 
multiple thereof. They are sold both to banks and to private 
investors. The company carries a 20% margin of collateral. 
On April 1, 19 14, according to the company's published state- 
ment, the total collateral held by the trust was in excess of 
$800,000 based on 1,073 accounts, showing an average amount 
of $795.22 in each account. The company features the wide- 
spread distribution of risk due to the small sum represented 
by each account. Most of the financing corporations, however, 
which handle commercial accounts receivable, themselves re- 
assign the paper which they take over, with their own indorse- 



4io 



INTERNAL FINANCIAL MANAGEMENT 



ment, to the banks with which they do business. They make 
a point of the fact that accounts or notes can be assigned and 
yet the collections may remain in the hands of their clients, 
thus insuring that the assignment is kept confidential. 

The Commercial Credit Company of Baltimore advertises 
that manufacturers and jobbers may sell to them $200,000 
of notes during any year, at a total cost of $2,500, provided 
they are paid within 30 days. Inasmuch as this is at the rate of 
1 % per month, plus a commission charge of ^ % on the first 
$100,000 of accounts, it is clear that the rate of discount which 
the manufacturer or jobber must pay is high; yet the accom- 
modation that he receives may be well worth the discount. 

These companies usually loan up to about 75 to 80% of 
the face value of the paper which they accept as collateral. 
Sometimes a fixed line of credit is granted to a client, against 
which a corresponding amount of collateral is constantly main- 
tained (paid or bad accounts being continually replaced by 
fresh ones), and sometimes a separate loan is made against 
each given block of collateral, each loan being regarded as a 
new and distinct transaction. 

An Unusual Problem 

The special problem that we have just been considering — 
the problem of converting current assets into cash — comes up 
in nearly all lines of business, and in many different forms. 
While it is not necessary to consider all possible variations, 
one problem in this field which is somewhat peculiar and 
which is also illuminating, may be described. The problem 
can best be stated in the words of the man who is facing it : 

I am engaged in a paving contract for the city of 
.... payment for which is given to me, not in cash, but 
in special tax bills issued against the property along the 
streets that are being paved. These tax bills are evidence 
that an assessment has been levied against the property. 



REQUIREMENTS FOR WORKING CAPITAL 4II 

They are delivered to the contractor who may make his 
own collections on certain conditions; or the tax may be 
paid to the City Treasurer who will transmit it to the 
owner of the tax bills. The bills bear 7% interest after 
maturity. In case of non-payment, the owner of these 
tax bills must, at his own expense, bring suit within two 
years and, inasmuch as the tax bills take precedence over 
everything except general state, city, and county taxes, 
may readily enforce collection. However, suit cannot 
profitably be instituted until toward the end of the second 
year, and many property owners who are aware of this 
fact allow them to run throughout nearly the whole 
period. The average length of time before the tax bills 
are paid is about five months. 

These tax bills are not readily salable either to bankers 
or to investors ; although they are exceptionally well 
secured and draw 7% interest, the time of payment is 
so uncertain that no one desires to have his money tied 
up in them unless he is compensated by an exceptionally 
heavy discount, which usually amounts to 10%. 

On the other hand, in my contracting business I need 
to turn over capital quickly, and find that tying up 
money in these slow bills cripples my capacity to handle 
work. 

Here is a problem that is unusually difficult because of the 
non-commercial character of these tax bills, and also because 
of their uncertain maturity. It was suggested that the only 
solution in this case is to use the tax bills as collateral for 
notes either to be discounted at banks or to be sold to private 
investors. It would be necessary that the arrangement as to 
collateral should be sufficiently elastic so that as rapidly as 
some of the bills were paid ofT, others would be substituted. 
The contractor would then be able to give his personal notes 
of a definite date of maturity and, in case the tax bills were 
not paid with sufficient promptitude to meet the notes, he 
would then have left the recourse of selling the remaining 
tax bills at a heavy discount, thus enabling him to take care 



412 



INTERNAL FINANCIAL MANAGEMENT 



of his own notes. At the worst, this method should be less 
expensive than the usual method of selling the notes outright. 
Unless there were some unexpected failure on the part of a 
number of taxpayers to meet their obligations, the contractor 
would probably be able to borrow funds required in his busi- 
ness at no more than the usual bank discount rates. It is 
understood that this suggested course of action has been fol- 
lowed and that by this method of converting some of his 
current accounts into cash the contractor has been able to 
proceed with the normal development of his business. 

Working Capital to Provide for Seasonal Variations 

A great many companies work under the handicap of 
extreme variations in the amount or the character of their 
business from one season to another. This was formerly 
true, for example, in the automobile business. During the 
early period of the popularity of pleasure vehicles the great 
mass of sales were made in the spring and early summer of 
each year; it is reported that in this industry the seasonal 
variation is being much reduced. Manufacturers of rubber 
goods, especially rubber shoes, find their sales concentrated 
at certain seasons; the same thing is true of manufacturers 
of agricultural implements, of sporting goods, and of many 
other products that will readily occur to every one. Manu- 
facturers of textiles, of beet sugar, and of other products 
made from raw materials gathered from the soil are under 
the necessity of buying heavily at certain seasons of the year 
in order to secure the benefit of minimum prices. In all these 
lines of industry, either large stocks of finished products must 
be accumulated during the remainder of the year in order to 
meet the requirements of the busy season, or large stocks of 
raw materials must be purchased at a given season and grad- 
ually used up during the remainder of the year. In either 
case it is clear that much larger sums of money must be tied 



REQUIREMENTS FOR WORKING CAPITAL ^3 

up in working assets during certain periods than during other 
periods of the year. This is a situation that involves unusual 
difficulties and greatly affects the amount of working capital 
that is required. The usual method is to secure a gradually 
increasing amount of bank loans as finished products are ac- 
cumulated which are rapidly paid off during the sales season ; 
or, if the other situation prevails, a large loan is effected dur- 
ing the buying season which is gradually paid off during the 
remainder of the year. Dependence upon bank loans exclu- 
sively, however, is unsafe, as many companies have discovered. 
Textile manufacturing companies have been peculiarly subject 
to failure because of their inability, owing to some unforeseen 
contingency, to meet the obligations held by their banks. Some 
years ago, when the so-called "Sugar Trust" desired to obtain 
control of an important beet sugar refinery, it is alleged to 
have obtained this result by secretly buying up all the short- 
lime notes given by the sugar refinery during its purchasing 
season and then demanding prompt payment of these notes 
instead of granting the customary partial renewals. As a 
result, the prosperous refinery suddenly found itself confronted 
with the prospect of bankruptcy and was forced to surrender. 
Although it would not be economical for companies en- 
gaged in seasonal industries to keep themselves supplied with 
the amount of working capital that is required at the maximum 
period of each year, it is highly desirable and prudent that 
they should carry a much larger working capital than would 
be required during the off seasons. This is a part of their 
normal expense of doing business. Such companies some- 
times find it advantageous to invest their surplus cash reserves 
during the off seasons in short-term securities. 

Month-by- Month Calculations 

It was remarked at the beginning of this chapter that it 
would be impracticable to attempt to draw up any invariable 



414 



INTERNAL FINANCIAL MANAGEMENT 



formula for calculating the amount of working capital required 
in any given concern. We must content ourselves with the 
general statement that working capital requirements vary 
roughly in proportion to the volume of business, the length of 
period of manufacture, the average length of credit extended 
to customers, and the extent of seasonal variations in volume 
of business, and that they vary roughly in inverse proportion 
to the rapidity of turnover, length of credit obtained in 
purchases of goods, and the facilities available for converting 
current assets into cash. These are the factors to be taken into 
account. 

Inasmuch as the customary unit of time used in reckoning 
most commercial operations is the month, it is worth while, 
in all close thinking and figuring as to the working capital 
requirements, to make estimates on a month-to-month basis. 
An estimate of this nature relating to a hypothetical case of 
a house doing an instalment business has already been given 
and will serve as an illustration of the method that should be 
followed in making up all such estimates. If all the factors 
that have just been named are known, and assuming in addi- 
tion that the various costs of manufacture or of purchase, 
selling, overhead administration, and the like are known, there 
will be no difficulty in figuring out just what the cash outgo 
and cash receipts of each month will amount to. This will 
show the working capital requirements month by month. By 
adding a liberal margin to cover faulty estimates and contin- 
gencies, the approximate amount of working capital required, 
even for a new corporation, can be estimated. In the case of 
an established corporation, which has behind it years of experi- 
ence and of records, the information that is desired can be 
worked out with greater accuracy. 



CHAPTER XVIII 

DETERMINATION OF NET INCOME 

Formula for Income 

The chapters preceding have dealt with such subjects as 
the financial forms of business enterprises, the various types 
of shares and of obligations that may be issued, the selection 
of securities that are adapted to all the needs of the corporation 
and to the security market, the construction of a correct 
financial plan, the promotion and initial financing of a new 
enterprise, the various methods of selling securities and thus 
raising the capital required, and the principles which determine 
the investment of that capital in fixed and in working assets. 
This completes our study of the various stages in the creation 
and financial organization of a concern. The remaining chap- 
ters deal with the management of companies that are already 
established and with the exploitation and reorganization of 
companies that are unfortunate or mismanaged. 

The first questions that arise in the financial management 
of a going, profit-making concern have to do with the de- 
termination and distribution of its income. The determination 
of income may be regarded as primarily a problem of account- 
ing, but it is also a financial problem. As was pointed out in 
Chapter I, the line of distinction between financial and 
accounting questions is not always to be sharply drawn. We 
will not be trespassing, then, on the exclusive territory of our 
friends, the accountants, if we take up for brief review the 
question of how corporate income is and should be determined. 

For purposes of illustration the following two statements 
of income are reproduced. The first from a recent report 
of the American Locomotive Company is in the following 
form: 

415 



4I 6 INTERNAL FINANCIAL MANAGEMENT 

Gross Income $29,987,438 

Operating Expenses, Including Manufacture, Mainte- 
nance, and Administrative Expenses and Depreciation 
Charge 27,425,187 

Net Income. $2,562,251 

Interest, Taxes, and Other Fixed Charges 486,124 

Surplus for the Year $2,076,127 

Preferred Dividends 1,750,000 

Surplus Available as Earnings on Common Stock $326,127 

Equivalent on Common Stock to i-3% 

Dividends on Common Stock 

Carried to Surplus Account $326,127 



A much more detailed income statement is that of the 
Union Pacific Railroad Company, which is as follows : 

Freight Revenue $59> 2 53»344 

Passenger Revenue 18,817,047 

Mail, Express, and All Other Transportation Revenue. .. 6,726,317 

Incidental Revenue 2,161,587 

Total Revenue $86,958,295 

Maintenance of Way and Structures $10,900,925 

Maintenance of Equipment 12,101,212 

Total Maintenance $23,002,137 

Traffic Expenses 2,061,971 

Transportation Expenses 23,108,140 

Miscellaneous Operations Expenses 1,313,189 

General Expenses 2,811,421 

Transportation for Investment — credit 160,lJf3 

Total Operating Expenses $52,136,715 

Taxes '..... 4*641, 474 

Total Operating Expenses and Taxes $56,778,189 



DETERMINATION OF NET INCOME 



417 



Revenues Over Operating Expenses and Taxes $30,180,106 

Other Operating Income 1,276,138 

Total Operating Income $31,456,244 

Fixed and Other Charges 15,028,285 

Surplus from Transportation Operations After Deduct- 
ing all Fixed and Other Charges $16,427,959 

Income from Investments and Other Sources 11,964,064 

Total Surplus $28,392,023 

Less Dividend on Preferred Stock at 4% Per Annum 3,981,740 

Surplus After Deducting Dividend on Preferred Stock. . $24,410,283 
Equivalent on Common Stock to 10.98% 

Amount Required to Pay Dividend on Common Stock at 

Rate of 8% Per Annum $17,783,328 



Surplus After Deducting all Fixed and Other Charges 
and Dividends on Preferred, and Common Stock $6,626,955 



The above examples show the essential steps in calculating 
income, which are as follows : 

1. State gross earnings. 

2. Deduct operating or manufacturing expenses, includ- 

ing selling, administrative, maintenance, and de- 
preciation. 

3. The result is net earnings from operation. 

4. Add income from other sources. 

5. The result is total net income. 

6. Deduct taxes, interest, rentals, sinking fund charges, 

and other fixed charges. 

7. The result is surplus for the year applicable as earn- 

ings on shareholdings. 

8. Deduct preferred dividends. 



4 i8 INTERNAL FINANCIAL MANAGEMENT 

9. Deduct common dividends. 

10. The result is surplus from the year's operations to be 
credited to surplus account. 

It seems hardly worth while to point out that income and 
expenditure are by no means identical with cash receipts and 
cash disbursements, though this elementary distinction is not 
always grasped, even by learned judges and lawyers. It has 
been pointed out, for instance, by an English authority, that 
among the legal judgments which have been delivered in the 
courts of the United Kingdom are such absurdities as the 
following:* 

Profits for the year, of course, mean the surplus in 
receipts after paying - expenses and restoring the capital 
to the position it was in on the 1st of January in that 
year. 

Fixed capital may be sunk and lost and yet the excess 
of current receipts over current expenses may be applied 
in payment of a dividend. 

It has been only a few years since the Attorney-General 
of the United States interpreted the law imposing a tax on 
corporate income, which had just been passed by Congress, 
as meaning that a tax had been imposed on the cash receipts 
minus cash disbursements. His decision was promptly over- 
ruled, but among accountants it has not been forgotten. 

Honesty in Stating Gross Earnings 

In connection with the preceding paragraph, it must be 
admitted, however, that the conception of the word income 
as referring only to net cash receipts, has the advantage of 
being much simpler than the present significance of the word. 
Income as understood in modern business includes all the 
various kinds of realized gain from operations during a given 
period. This gain may be realized in the form of increased 



'Francis W. Pixley, "Auditors: Their Duties and Responsibilities," pp. 515-517. 



DETERMINATION OF NET INCOME 



419 



accounts receivable, enlarged facilities for production, reduced 
obligations, or in various other ways. Inasmuch as the ex- 
tent of the gain is frequently difficult to measure, there is 
left considerable latitude for the exercise of discretion and 
good faith on the part of officials in estimating income. It 
is sometimes possible for them, if they are not governed by 
the strictest integrity, to stretch or reduce the statement of 
income which they give to their stockholders and to the pub- 
lic in order to serve their personal interests. 

In the first report of the United States Realty and Con- 
struction Company, earnings for the nine months' period ended 
June 30, 1903, were given as $1,417,000; but it later appeared 
that $487,000 of these earnings consisted of "profits from 
estimated increase in the value of investments still held" and 
$577,000 consisted of "profit on buildings in progress, esti- 
mated proportion accrued. ,, The first item is typical of a 
practice that is frequently advocated by corporate officials 
who desire to make a showing of profits that have not been 
earned through operation. Real estate, securities, stocks of 
merchandise, and the like are constantly fluctuating in value. 
If any of these properties is actually sold and a profit is real- 
ized, it is entirely proper that this profit should be credited 
to surplus, but it should certainly not be credited to the sur- 
plus arising out of operations during a given period. So 
long as the profit is not realized, but exists simply on paper, 
it is almost universally agreed that it should not be credited 
at all. Officers who advocate marking up profits on account 
of fluctuations in value of permanent holdings are frequently 
the first ones to find some plausible reason for declining to 
mark down profits when these same holdings decline in value. 
If a company is engaged in the business of buying and selling 
real estate or securities, the case may be different and may 
be worthy of further consideration, but in other cases such 
profits should not be credited unless realized. 



420 



INTERNAL FINANCIAL MANAGEMENT 



As to the second item, there is undoubtedly more room for 
debate. It would seem unfair that companies which cus- 
tomarily engage in long-time contracts, such as the construc- 
tion of buildings and the like, should credit no profits to the 
period in which the construction work is going on. On the 
other hand, it was found in the case of the United States 
Shipbuilding Company that the anticipated profits on large 
contracts, which had been counted in the millions of dollars, 
were never realized, but actually turned into a loss at the 
completion of the contracts. Estimates of profits on un- 
completed contracts are likely to be made by officers whose 
judgment may be warped by their own interests. Such items 
are to be considered, therefore, with some degree of skepticism. 

A curious difficulty of accounting in arriving at gross 
profits is illustrated in the financial history of the American 
Malting Company. It appears that in the malting process 
each bushel of cleaned barley produces 112 to 115% of a 
bushel of malt. This increase is a normal incident in the 
process of manufacturing malt and it is claimed should be 
taken into consideration as a source of profits. It is, how- 
ever, at least questionable whether anticipated profits from 
this source should be counted. It probably is time enough to 
count them when the profits have actually been realized. 

Another fruitful source of error in stating gross earnings 
is overoptimism in the valuation of finished and partly 
finished products and raw materials on hand. Sometimes bal- 
ance sheets are found in which inventories amount to several 
times the aggregate of gross sales. In such cases it is clear 
that even a slight excess valuation of the inventories may be 
the real source of a considerable proportion of the alleged 
profits. Where the item of inventories appears to be con- 
stantly growing, from year to year, more rapidly than sales 
and profits, the estimate of gross earnings should certainly 
be subjected to close examination. 



DETERMINATION OF NET INCOME 



421 



At the formation of the American Bicycle Company in 
1898, the constituent plants were taken in largely on the basis 
of their reported net earnings. From later developments 
and analysis it seems probable that these net earnings were 
in many cases overstated, by reason of the fact that inventories 
of dead stock which should have been charged off to profit 
and loss were carried at their full valuation.* 

It should never be forgotten that, by reason of the dis- 
cretion which is necessarily accorded to them in estimating 
gross earnings, corporate officials ought to be exceptionally 
conservative, and for their own protection should rely to a 
great extent upon the judgment of impartial accountants and 
other outside advisers. Misstatements of gross earnings are 
not made necessarily with dishonest intentions; the men who 
are most interested in the business are frequently the very 
ones who are most easily persuaded that an exaggerated esti- 
mate of unrealized earnings is sound and reliable. 

Operating Expenses and Deductions 

There is usually little question as to the actual outgo for 
raw materials or other purchases, labor, selling expenses, 
salaries of officers and other administrative overhead, etc., all 
of which, are directly chargeable to the various accounts that 
are grouped under the general heading of "Operating Ex- 
penses." Even here, claims are sometimes advanced in favor 
of charging such expenditures as for. advertising and for 
training employees, to capital accounts rather than to operating 
expenses, on the theory that such expenditures are a permanent 
benefit to the business. If such claims are to be allowed at all, 
which is usually doubtful, it is regarded as correct practice to 
charge items of this nature to some such account as "Deferred 
Expenses," which is carried on the balance sheet for the time 



# The illustrations in this section are, for the most part, taken from Dewing's 
Corporate Promotions and Reorganizations." 



4 22 INTERNAL FINANCIAL MANAGEMENT 

being as a capital account but is intended to be written off 
within a brief period. 

There is little, if any, question also as to most expenditures 
for repair and maintenance of the permanent property of the 
business. This property must be kept up as nearly as possible 
to its original standard of efficiency, and the expense of so 
doing can scarcely be regarded otherwise than as a portion of 
the total expense of operation. Going a step farther, it is well 
to point out that many new companies make a serious error in 
that they do not at once begin to charge against profits a fair 
allowance which will take care of at least a portion of the 
repairs and other maintenance expenses that are to be expected 
in the course of a few years. Owners of apartment houses 
and other city real estate are frequently negligent in this 
respect to their own detriment. A building of this character 
may run for some years with comparatively slight outlay for 
repairs; then all at once everything is out of order. Either 
large sums must be expended and charged against operating 
expenses or the character of the building will change for the 
worse and a lower income will be obtained. The same line 
of reasoning applies to many manufacturing establishments. 
Electric railways up to the present time have not, on an 
average, consumed nearly so large a ratio of their gross earn- 
ings in maintenance as do steam lines. Whether the ratio will 
later become larger is an undecided question, but perhaps it 
may reasonably be assumed that it will increase. Unless 
provision is made in advance, the results cannot be pleasing 
to shareholders in such companies. The subject of main- 
tenance and repairs will be again referred to a little farther 
on in this chapter. 

Reserves 

Nearly all well-managed corporations charge against the 
profits of each year an estimated sum, or a number of distinct 



DETERMINATION OF NET INCOME 



423 



estimated sums, which are intended to provide for losses and 
expenses that will probably arise in the future but which are 
incident to the operations of the current period. The sums 
so charged are credited to reserve accounts, which are carried 
on the balance sheet of the company. As to the nature and use 
of these reserve accounts, there is much misunderstanding. 
They do not consist, as people seem sometimes to imagine, of 
funds of cash or property set aside for the purpose of meeting 
future expenses. It is, in fact, easily possible that a company 
may accumulate large reserve accounts and yet be quite unable 
to meet the anticipated expenses when they actually arise. 
The essential character of all reserves lies in the fact that they 
constitute a deduction from profits. The reserves exist only 
in the form of entries and figures in the company's books of 
account. It is quite possible that a firm which carries no 
reserves on its balance sheet may be just as conservatively 
managed as the one which has large reserves. But the proba- 
bilities are the other way, for the reason that proper estimates 
in favor of reserve accounts assist the officers and stockholders 
of a company in gauging the true status of the business and 
therefore discredit exaggerated optimism. 

The most common form of reserve is that for depreciation 
in the value of fixed assets, due to wear and tear, obsolescence, 
etc. Depreciation on account of wear and tear may be esti- 
mated in advance with some accuracy, but depreciation for 
obsolescence is always of uncertain amount. No one can 
foresee what changes in taste or fashion, what unthought-of 
inventions, or what improvements in organization may take 
place, which will perhaps render useless, or partly useless, 
much of the company's plant, machinery, or other assets. The 
best that can be done is to make a fairly liberal estimate, based 
on the experience of the past and trust that it will be sufficient 
to keep the book value of fixed assets always well within the 
limits of actual value. If this result is not accomplished, then 



424 INTERNAL FINANCIAL MANAGEMENT 

the depreciation reserve is insufficient and net income is over- 
stated. 

Although the presence of depreciation as an actual factor 
in every business can scarcely be denied, yet the absence of 
any depreciation charges and reserve accounts on the books 
of certain corporations is defended by fallacious arguments. 
For example, many street railway companies and other public 
utility corporations decline to make any deduction for depre- 
ciation charges from gross income. The claim which many of 
them advance is that the value of their franchises is constantly 
increasing and is sufficient to offset the admitted decline in 
value of their road-bed and equipment. This kind of argument 
is apparently advanced simply to justify a line of action pre- 
viously determined upon. It is based upon a two-fold fallacy. 
First of all, granting that there is a steady rise in the value of 
the company's franchises and that this rise should be taken 
into the income account, it should then be valued by itself and 
shown as a source of income, while depreciation charges should 
be shown as a deduction from income ; otherwise there is not 
even an attempt to make up a fair and reliable income state- 
ment. In the second place, experience has by this time shown 
that the alleged increase in the value of franchises is a highly 
uncertain factor. Most public utility enterprises are subject 
in a peculiar degree to legislative control and the legislature 
usually takes care that franchise values are not permitted to 
increase with excessive rapidity. The, better managed public 
utility companies are gradually falling into line and are 
forming adequate depreciation reserves. 

Another fallacy is clearly seen from the last annual report 
of the Canadian Locomotive Company, which includes this 
remarkable assertion : "We have not added anything to de- 
preciation reserve account as we feel that, our plant being 
new, the $75,000 already at the credit of this account is suf- 
ficient." 



DETERMINATION OF NET INCOME 425 

Following out the line of reasoning of the directors of 
this company, it is evident that depreciation reserves are to 
be set aside only when the period has arrived in which they 
are actually needed. This makes the so-called depreciation 
reserve and the account for repairs and maintenance, practically 
identical, and does away with the only genuine reason for the 
creation of a depreciation reserve. The London Economist 
has put the truth of the situation clearly in the following 
words : "Depreciation allowances are all the more necessary 
in a boom period, because there is always the practical certainty 
that the boom will decline more or less suddenly and will 
leave overvalued stock on hand." Companies that have new 
plants and are enjoying prosperity are the very ones which 
should be setting aside liberal reserves for depreciation. 

It is not intended in this last sentence, however, to sug- 
gest that the practice of writing off depreciation reserve irregu- 
larly by arbitrarily setting aside such sums as can conveniently 
be spared out of the annual surplus, is one to be encouraged. 
This practice is followed, it is true, by some of our greatest 
and best-managed concerns, notably by the United States 
Steel Corporation. But it is essentially unsound. Deprecia- 
tion is not a theory or a vague notion in some one's head ; it 
is an actual element in the operation of every business; it is 
going on night and day; through all seasons; year after year; 
in periods of depression as well as in periods of prosperity. 
The losses due to depreciation should constitute, therefore, a 
regular charge against gross income. The amount of that 
charge should be estimated as accurately as possible and should 
be adhered to year after year; otherwise we get a purely 
fictitious showing of net profits. If large sums are charged 
off in one year and nothing is charged off the next year, the 
final showing of profits in the two years may be about uni- 
form, whereas the business has perhaps really suffered an 
enormous fluctuation. The purpose of accounting should be, 



42 6 INTERNAL FINANCIAL MANAGEMENT 

not to conceal such facts, but faithfully and clearly to set them 
forth. 

Depreciation of intangible assets, as well as depreciation 
of plant, road-bed, equipment, and the like, should be liberally 
estimated and provided for. In fact, it is generally agreed 
that the practice should be to "write off" intangible assets 
at an especially rapid rate, even though their real value may 
not be decreasing. Many bankers and other financial men 
have a very high regard for what is called a "clean" balance 
sheet, that is to say, one which includes only tangible assets 
at their cost value with ample depreciation reserves. This 
preference seems to be in many cases little more than a preju- 
dice, inasmuch as such assets as patents, copyrights, good- 
will, and the like may be permanent and productive, and 
may properly be carried as real assets. Nevertheless, even 
where this is the case, it is often advisable to cater to the 
prejudice that has been created through the unscrupulous and 
reckless valuation sometimes placed on intangible assets, and 
to carry out the policy of "writing off" with considerable 
rigor. One company which follows this practice is the East- 
man Kodak Company, which carries depreciation reserves 
of over 25% against its book valuation of "properties, patents, 
good- will, etc." 

There are many other kinds of reserves which should be 
carried if the business of a company is to be based on sound 
accounting and finance. The business of many companies, 
for example, requires them to enter into contracts which in- 
volve immediate payment on the part of the purchaser of their 
products, combined with a liability assumed by the company 
to render future service. A company publishing a magazine 
usually collects subscription payments in advance and con- 
tracts to deliver the magazine over a twelve months' period. 
This being the case, it is clear that the company actually earns 
the subscription payment only as it proceeds through the 



DETERMINATION OF NET INCOME 427 

year with the delivery of its magazine, and that it would be 
improper to credit the subscription payment as income of the 
week or month in which it is received. The modern custom 
among magazine publishers is to credit an account usually 
called "Unearned Subscriptions" for payments sent in by sub- 
scribers, and at the close of each month to debit this account 
and credit another account called "Subscription Earnings" 
for the proportion actually earned by sending out magazines 
during that month. 

Various asphalt paving companies include in their paving 
contracts guarantees to keep the streets which they pave in 
repair for a certain number of years. At first the guarantee 
was usually 5 years, which in New York was extended to 
15 years, and in some other cities to 10 years; later the guar- 
antee period was gradually reduced to from 2 to 5 years. 
At the time when the guarantee system was first introduced, 
insufficient reserves to cover expenditures under these guaran- 
tees were set aside, and consequently profits at this stage were 
greatly overestimated. During 1899 the accounting methods 
of the Barber Asphalt Paving Company showed a nominal 
profit of $474,000. Later, the Audit Company of New York 
estimated the actual profits to have been $35,700. Most of 
the discrepancy between the two figures was due to the fact 
that the company originally failed to set aside sufficient 
reserves to enable it to meet its guarantees. 

Future outgo on contracts that are taken into current in- 
come account should be watched and provided for with the 
greatest care. Companies that are conservatively managed 
will look out for future or contingent expenses of this kind. 
In a recent balance sheet of Babcock and Wilcox, for example, 
one item consists of "Reserves for further estimated expendi- 
ture on orders invoiced." An account under some such title 
should be included on many other balance sheets where it is 
now missing. 



42 8 INTERNAL FINANCIAL MANAGEMENT 

Operating Expenses and Betterments 

We have spoken above of charges for repairs, renewals, 
maintenance, and depreciation as being properly included in 
operating expenses or in deductions from gross income, and 
have emphasized the necessity for liberal allowances. There 
is, however, a possible, although not so frequent, danger of 
going to the opposite extreme. Depreciation charges may 
be too high, and thus the showing of earnings may be unduly 
depressed. Boards of directors sometimes find it to their 
advantage to see that reports of low earnings are given out 
to stockholders and to the public over a given period, so 
that they may take advantage of this misinformation to buy 
up the company's shares at bargain prices. 

Again the various accounts included under the general 
headings of "Repairs," "Renewals," and "Maintenance" may 
be stretched so as to include outlays for betterments. In 
this case earnings are apparently depressed and the capital 
accounts remain stationary although the capital assets are at 
the same time being built up. Something of this kind has 
happened most frequently in the management of railroad 
companies in the United States. Conservatively managed 
companies have frequently included in their "Maintenance" 
accounts, expenditures for reballasting, for laying heavier 
rails, for putting in permanent culverts and even bridges 
and for purchasing new locomotives and cars. After this 
practice has been carried on over a period of years and the 
property has been put into excellent condition, the statements 
of earnings are allowed to expand to their correct proportion 
and the stockholders of the second period are perhaps given 
enlarged dividends or a "melon" of some kind. 

A notable instance is the Lehigh Valley Railroad Company 
under the management of President Walter from 1898 to 
1904. During these six years the stockholders noted in. each 
year's accounts that the charges for maintenance, repairs, etc., 



DETERMINATION OF NET INCOME 



429 



were growing to unprecedented heights and that the net profits 
were correspondingly reduced. They suspected the truth — 
that expenditures for betterments were being charged into 
maintenance accounts — and many of them protested, but with- 
out effect. After the close of the Walter regime, the prop- 
erty was found to be in remarkably good condition and the 
subsequent financial history of the Lehigh Valley has been 
one of progress and good earnings. 

Is Concealment of Betterment Expenditures Advisable? 

The management in the Lehigh Valley case, and in many 
other similar cases, took the attitude that they were the ones 
best acquainted with the needs of the corporation and were 
better entitled than were the stockholders to judge as to 
the necessity for betterment expenditures. They believed, 
further, that stockholders, if the decision were left to them, 
would not have sufficient patience or be sufficiently interested 
in the development of the corporation to be willing to have 
large sums set aside out of each year's earnings in order to 
build up the capital assets. It might have been possible, to be 
sure, to finance the required betterments by fresh issues of 
obligations and of stock, but the management believed that in 
view of the past financial record of the company, this could not 
be economically accomplished. They took, therefore, the 
course which seemed to them proper, of concealing — or par- 
tially concealing — the expenditures for betterments, and thus 
improved the property of the corporation without the knowl- 
edge or consent of the stockholders. 

The motives of the management in this case were unim- 
peachable, and there can be no doubt, as we look back, but 
that the Lehigh Valley and its stockholders as a body have 
been greatly benefited by the policy that was followed. And yet 
this conclusion may not dispose of the whole question. 

The stockholders of most large corporations at the pres- 



43° 



INTERNAL FINANCIAL MANAGEMENT 



ent time can scarcely be regarded as a permanent body of 
individuals. Shares are constantly being shifted back and 
forth in the stock market; many shareholders do not regard 
their 1 holdings as permanent assets, but rather as temporary 
investments which they intend to sell whenever they may need 
money. Naturally, each set of stockholders desires to secure 
as large returns as possible, and emphatically does not desire 
to have earnings secretly withheld in order that future stock- 
holders may reap the benefit. Their first interest, usually, 
is not in the corporation, but in themselves. And we must 
face the situation that actually exists in many large corpora- 
tions in which the interests of the stockholders and the inter- 
ests of the corporation are not quite identical. Under these 
conditions, which set of interests shall the directors elect 
to serve? Withers quotes, with full approval, the opinion 
which is forcibly, though dogmatically, expressed by Pixley, 
as follows:* 

It is not incumbent upon the directors to consider in 
any way individual shareholders, or a special group of 
shareholders, and certainly not those who make a practice 
of buying and selling shares and holding them for short 
periods. It is their duty to keep the capital of their com- 
pany intact, and to do their best to make it a permanent 
institution. 

Equally forceful and dogmatic opinions are often expressed 
by shareholders on the other side. 

Perhaps the most practical conclusion that can be reached 
is that the directors should consult both sets of interests and, 
when necessary, should compromise. Certainly they should 
protect and keep intact the property of the corporation. But 
in so doing they should endeavor to avoid injurious conceal- 
ment of facts or injustice to one set of shareholders as com- 



*Pixley's "Auditors: Their Duties and Responsibilities," quoted in Hartley Withers' 
'Stocks and Shares," p. 156. 



DETERMINATION OF NET INCOME 



431 



pared with the succeeding set. In case the corporation openly 
withholds dividends and piles up a surplus, shareholders know 
what is being done and the market prices of their holdings 
respond to the true status of the company's assets. This 
was demonstrated over a period of several years by the Read- 
ing Railroad Company, the shares of which were paying 4%, 
yet for years were sold at between 120 and 150. The ques- 
tion is not whether the accumulation of a surplus out of earn- 
ings is advisable, but whether concealment of the accumulat- 
ing surplus is advisable. Without failing to recognize the 
force of the argument that can be advanced in favor of con- 
cealment, it would seem that the reply to this last question 
should, on the whole, be negative. 

In those not infrequent cases where directors are with 
reason suspected of deliberately withholding and concealing 
earnings and piling up a secret surplus in order that they may, 
as individuals, profit at the expense of their fellow share- 
holders, there is, of course, no room for differences of opinion. 
This last case is simply one of exploitation. 

Two Classes of Betterments 

Before leaving this subject, it may be well to call attention 
to the two different classes of betterment expenses which are 
generally regarded as being properly financed in two different 
ways. One class consists of betterments which are certain 
to yield a definite, traceable return, either in the form of 
enlarged revenue or in the form of savings in outgo. When 
a railroad company, for example, decides to construct a tunnel 
and straighten out its line between two given points, it should 
be readily possible to calculate not only the cost of the better- 
ment, but also almost the exact amount of savings that it will 
effect in fuel, labor and the like. When a manufacturer puts 
in a new piece of machinery in order to turn out a better grade 
product, he should usually be able to calculate how large will 



432 



INTERNAL FINANCIAL MANAGEMENT 



be the increase in the price and total sales of the new 
product. 

The second class of betterments consists of those which are 
considered desirable and well worth the expense involved, but 
which will not yield direct and traceable profits. A depart- 
ment store, we will say, decides as a matter of business policy 
that it should build and furnish a handsome recreation and 
lunch room for its employees. The officers are satisfied that 
the result will be to increase loyalty, interest, and efficiency,, 
and thus indirectly build up the store's prestige and increase 
its sales. Nevertheless, it will be impossible to arrive at a 
mathematical calculation of these results. The directors of a 
bank decide that they will put up a fine new building which 
will constitute the best kind of a standing advertisement of 
the bank's stability. Much of the cost of the building, how- 
ever, will not be represented by any adequate return on the 
invested capital, and must be regarded, therefore, as a better- 
ment which does not yield traceable results. 

By general consent among the officers and directors of 
great corporations, it is agreed that the first class of better- 
ments may properly be financed by the issuance of fresh securi- 
ties, if it can readily be shown that the interest or dividends 
on these securities will be provided out of the enlarged income 
or the savings made possible by the betterment. The second 
class of betterments, however, should be provided for out of 
surplus. They may prove to be highly profitable, but there 
is no certainty on that point. The only money that should 
be spent on them, therefore, should be money that has been 
accumulated out of the profits of the preceding years or that 
is currently accumulating. In case the judgment of the di- 
rectors should be wrong, and the betterments should not 
make for enlarged profits, the corporation would at least 
escape a loss that would be damaging to its credit. 

The Pennsylvania Railroad Company has, perhaps, been 



DETERMINATION OF NET INCOME 



433 



the most consistent follower of the principle that has just 
been presented. In financing $150,000,000 of improvements 
of the company in New York City terminals, including tunnels 
under the North and East rivers and the magnificent terminal 
building, approximately one-half the investment was provided 
by fresh issues of securities; the other half was provided by 
charges against the surplus of the Pennsylvania Railroad and 
allied companies. 

Another clear-cut example is furnished in the announce- 
ment of the London and South American Railroad Company, 
which in October, 1914, brought out an issue of £1,000,000 
5% redeemable preference stock. According to the London 
Statist, it was announced that the proceeds were to be used 
for electrifying certain sections of the suburban systems of 
the company: 

The decision was come to that it would not be right 
for the whole cost of the work to be charged against 
capital; it was realized that to some extent the adoption 
of electric traction is in reality an alteration in the 
method of working; the one kind of traction merely being 
substituted by another: Therefore, it was decided that 
only the cost of the power-house, substations, and the 
third rail, should be charged against capital account, and 
that other items, such as alteration of the rolling stock 
and structures, the bonding of rails, and the various other 
expenses, should not be a permanent charge upon the 
revenue of the company. 

Too many companies rush ahead blindly in making what- 
ever betterments appeal strongly to the operating officials, 
without giving sufficient thought to the soundness of their 
methods of financing the betterments. One of two results 
is almost certain to follow; either the company provides the 
fresh capital required too largely by the issuance of securities 
which may in time become a dangerous burden; or the ex- 



4 34 INTERNAL FINANCIAL MANAGEMENT 

penditures for the betterments are unjustly saddled upon the 
shoulders of those who happen to be shareholders at the time 
and who are deprived of a portion of the earnings to which 
they feel rightfully entitled. In this latter case, the policy 
may be followed either openly, by making direct charges 
against surplus, or secretly, by including expenditures that 
are really for betterments under operating expenses. 

All these courses of action are objectionable. The real 
solution is to be found in the careful division of the better- 
ments into the two classes that have been named and in the 
selection of corresponding methods of financing. In this case 
it will probably be comparatively easy to convince shareholders 
that they should be willing to sanction reasonable charges 
against surplus to pay for betterments of the second class, and 
it will not be necessary to conceal these betterments in any 
form. In that case, assuming also that the gross earnings of 
the company are carefully and honestly stated, and that operat- 
ing expenses include all the charges for depreciation and other 
reserves that should be made, the result will be to arrive at 
an accurate and just determination of net income. 



CHAPTER XIX 

DIVIDENDS 

Net Income and Dividends 

After the amount of a corporation's net income has been 
determined, it is in order for the directors to consider how it 
shall be distributed. As was indicated in the preceding chapter, 
net income is distributed normally through three channels, 
which are respectively labelled : fixed charges, dividends, and 
additions to surplus. 

As to "Fixed Charges'' there is little that needs to be 
said at this point. They consist of taxes, payments on leases 
and rentals, and interest payments on the funded obligations. 
The amount of fixed charges (except for taxes) is determined 
by the amount and form of the company's capitalization and 
of its long-term contracts. We have already given considera- 
tion to the problems involved in drawing up a financial plan 
and in deciding what, if any, bond and note issues shall be put 
out. At the time when net income for a given period has been 
determined and its distribution is under advisement, the pay- 
ments for fixed charges are no longer questions within the 
discretion of the directors or of any one else connected with 
the company. Unless they are paid as they become due, the 
company will at once cease to be solvent. We will assume, 
therefore, that net income is more than sufficient to meet fixed 
charges, and that there is remaining a balance available for 
dividends and surplus. 

As to the distribution of this balance between dividends 
and surplus, the board of directors is the sole authority. 
Neither officers nor stockholders, as such, have any voice 

435 



436 



INTERNAL FINANCIAL MANAGEMENT 



in the matter and there are few effective legal restrictions. 
We have before us, then, for treatment in this and in the 
following chapter, the two closely related questions : 

What principles should guide the directors in fixing 
dividends ? 

What principles should guide the directors in accumulat- 
ing and in using surplus? 

Two classes of dividends are to be considered : those which 
are preferred and cumulative (with which may be included 
so-called interest on income bonds), and those which are 
common or ordinary and have no special priorities. 

As to preferred dividends, much the same reasoning ap- 
plies as has just been stated with regard to fixed charges. 
There is left, to be sure, a much larger measure of discretion 
to the directors, who may, at their option, decide to defer the 
payment. But there is a corresponding penalty in the fact 
that the accumulated dividends constitute a growing barrier 
in the way of common dividends, and that the credit of a 
corporation is adversely affected by piling up large arrears 
of preferred dividends. For these reasons corporations that 
are earning sufficient profits and are in sufficiently strong finan- 
cial condition, usually pay their preferred dividends without 
much argument. There are, to be sure, some exceptions to 
this general statement, but the pressure in favor of payment 
of preferred dividends, wherever possible, is effective in the 
great majority of cases. 

Preferred dividends which are not cumulative belong in a 
different class. The interests of the common stockholders, 
whom the directors usually represent, require that non-cumula- 
tive preferred dividends should not be paid until common divi- 
dends can also be paid. Hence we may include all dividend 
charges which 'have priority, but are not cumulative, under 
our consideration of common or ordinary dividends. 



DIVIDENDS 437 

Average Rates of Dividends 

A valuable compilation showing the amount of railway 
stock in the United States which pays dividends, the percentage 
of this dividend-paying stock to all outstanding stock, and the 
average rates of dividends over a period of years, is reprinted 
below :* 





Amount of Stock 
Paying Dividends 


JPercentage ot 

Stock Paying 

Dividends 


Average Kate on 
Dividend-Paying 
Stock 


Average ] 
on all Si 


1900 


$2,668,969,895 


45.66 


5-23 


2-39 


1901 


2,977,575,179 


51-27 


5.26 


2.70 


1902 


3,337,644,681 


5540 


5-55 


3.08 


1903 


3450737,869 


56.06 


570 


3.20 


1904 


3,643,427,319 


5747 


6.09 


3-50 


1905 


4,119,086,714 


62.84 


578 


363 


1906 


4,526,958,760 


66.54 


6.03 


4.01 


1907 


4,948,756,203 


67.27 


6.2Z 


4.19 


1908 


4,843,370,740 


65.69 


8.07 


5-30 


1909 


4,920,174,118 


64.01 


6.53 


4.18 


1910 


5,412,578,457 


66.71 


7-50 


5.00 


1911 


5,730,250,326 


67.65 


8.03 


543 


1912 


5,581,289,249 


6473 


7.17 


4.64 



It is of especial interest to note that from one-half to two- 
thirds of the corporate stock outstanding in the United States 
during recent years has been paying dividends. It is to be pre- 
sumed that the other one-half to one-third consists almost 
wholly of common stock which has a relatively small market 
value. Doubtless this non-dividend paying stock is made up 
only in part of securities on which the earnings are small. It 
must include a large proportion of the stock of new or growing 
corporations which are deliberately reserving their earnings 
for the purpose of building up the business. It is gratifying 
to observe the rapid increase during the years 1900 to 1908 
in the percentage of dividend-paying stock and in the average 
rates of return. From 1908 to 191 2, the earnings in propor- 

*Bulletin 66 of the Bureau of Railway Economics, Washington, 1914. 



438 



INTERNAL FINANCIAL MANAGEMENT 



tion to outstanding stock were not far from stationary. In 
judging these figures, it may, however, be assumed that a 
part of the rapid increase in stock from 1900 to 191 2 was due 
to stock dividends or other methods of "watering," so that the 
actual increase in earnings in proportion to the actual invest- 
ment of capital has probably been greater than the tabulation 
would indicate. 

In most other countries the showing could not be nearly 
so favorable. It is clear that under the best conditions capital 
which is invested in stock takes a considerable risk of going 
without dividend returns. 

Percentages of Earnings Devoted to Dividends 

An instructive tabulation of the income statements of about 
900 English companies for the year ended July 31, 1914, 
shows the following distribution of profits: 

Net Preferred Ordinary Surplus, 

Profits Dividend Dividend Reserves, etc. 

£ £%£%£% 

Breweries 2,409,759 486,255 20.2 1,312,820 54.4 610,684 25.4 

Gas 856,541 139,729 16.3 887,953 1037 *I7I,I4I *i9-8 

Iron, Coal & Steel. i,533,76l 275,244 17-9 669,196 43-5 589,321 38.5 

Shipping 770,861 104,895 13-6 326,952 42.2 339,014 44-2 

Teas, Rubber, etc. 535,699 31,247 57 400,384 75.0 104,068 19.3 

Trusts 160,725 25,663 16.0 109,220 67.9 25,842 16.1 

Waterworks 62,727 9,357 149 45,315 72-3 8,055 12.8 

Miscellaneous ....3,160,147 945,715 29.9 i,473,99i 46.5 740,441 23.6 

9,490,220 2,018,105 21.3 5,225,831 55.2 2,246,284 23.5 
♦Deficit. 

It appears from the above table that preferred dividends 
received 21.3 of the net profits of these 900 companies; or- 
dinary dividends received 55.2 ; and the balance added to 
surplus was 23.5. 

It should be noted in passing that the gas companies paid 



DIVIDENDS 439 

out in ordinary and preferred dividends, considerably more 
than their net profits, showing that they drew in this year upon 
the surplus accumulated in previous years. 

The London Economist comments on the above table as 
follows : 

As usual the iron and steel and shipping companies 
have adopted a conservative policy with regard to the dis- 
tribution of profits to their shareholders. Most of the 
rubber companies have no preference shares, and prefer 
to maintain their high dividends at the expense of the 
reserve funds. A very high percentage of the profits of 
the water and gas companies goes to the ordinary share- 
holders, and in the case of the latter large reductions 
have been made in the amounts carried forward for this 
purpose. 

Although similar compilations for companies in the United 
States are not available, it is probable that the results would 
be to show a much smaller proportion of earnings paid out 
in common dividends and a larger proportion reserved for 
additions to surplus. The tendency in European countries 
is much more strongly in favor of paying out the greater por- 
tion of earnings in the form of dividends than it is in the 
United States. Doubtless this is due in large part to the 
comparative instability of economic conditions in a rapidly 
growing country. It is due also, however, to the fact that 
different and in some respects more conservative standards 
of capitalization and of distribution of income have become 
established. This is a topic which will be more fully treated 
in the chapter following. It is in the meantime enough to 
point out that the statistics of a group of companies, although 
interesting and of some value as furnishing a standard of 
comparison, are not likely to prove of much assistance to 
directors in solving the problem for their own company. 
There are, however, principles which have been almost un- 



440 INTERNAL FINANCIAL MANAGEMENT 

consciously worked out through the experience of thousands 
of corporations, and which are now accepted as sound by most 
conservative business men. These principles furnish the 
safest and most satisfactory guide. 

Regularity of Dividends Desirable 

The principle of greatest practical importance is that reg- 
ularity in the dividend rate is highly desirable. This prin- 
ciple must be regarded as almost a discovery of the last 
generation or two. Formerly the unquestioned practice was 
to regard shareholders as standing in substantially the same 
relation as partners. They were supposed to be familiar with 
the status and fluctuations of the business and were expected 
to share in its ups and downs. If the enterprise enjoyed 
an exceptionally good year, it was accepted as a matter of 
course that the dividend rate would be correspondingly in- 
creased. If in the following year there was a sharp decline 
in profits, the dividend rate should be correspondingly cut. 
As a matter of fact, this is today the practice of a great 
number — perhaps the majority — of corporations. In so far 
as it is followed by close corporations, all the stock of which 
is held by men who are themselves active in the business and 
familiar with its every phase, it is probably unobjectionable. 
It is a matter of personal preference in many cases, and 
has the advantage of stimulating the interest of those share- 
holders who are active in the business to the highest degree. 

But the corporation which has shareholders who are not 
active in the business or familiar with it is in a different situ- 
ation. This remark applies with especial force to the great 
corporations that number their shareholders in the thousands 
or tens of thousands. The great majority of the shareholders 
of such corporations have only the barest information as to the 
manner in which the business is handled and as to the results 
that are being achieved, and are not sufficiently familiar with 



DIVIDENDS 441 

the business or sufficiently interested in it to absorb more 
detailed information if it were given to them. They regard 
their ownership of a company's stock purely as an investment 
of capital that will bring them an income. They buy a railroad 
or an industrial stock with much the same purpose as they 
would have in buying a real estate mortgage — the only purpose 
being that of securing a dependable income with a chance at 
profits. The object that is actually in their minds in making 
the purchase is not a partnership interest in a going enterprise, 
but certain pieces of paper called "certificates of stock" which 
at regular intervals will bring them dividend checks. 

To shareholders of this type regularity in their dividend 
returns is of the highest importance. They count upon these 
returns as a fixed portion of their income — indeed, in thousands 
of instances the living expenses of dependents are provided out 
of these dividends. Approximately half the stockholders of 
the New Haven Railroad are women. The effort of the 
directors of a corporation which includes a large proportion 
of shareholders of this type should clearly be to meet their 
needs by paying a permanent rate of dividends with the fewest 
possible fluctuations. This rate of dividends in a really stable 
and conservatively managed corporation never varies except 
when it is increased. And it is not increased until after the 
directors have assured themselves that in all human probability 
a later decrease will not become necessary. If there are un- 
usual, or possibly temporary, profits which it is thought wise 
to distribute, the directors of such corporations will ordinarily 
announce an "extra" dividend or once in a while will cut a 
"melon" in the form of a stock dividend or a subscription 
privilege. These extras, however, are to be regarded only as 
incidents which should not be allowed to disturb the regular 
and uninterrupted flow of dividends. 

The desirability of maintaining regularity of dividend rates 
rests not merely upon the duty of the corporation to its share- 



44 2 INTERNAL FINANCIAL MANAGEMENT 

holders, but also upon a substantial gain for the corporation 
itself. By reason of the fact that shares which yield regular 
dividends are in demand by so large a body of owners of 
capital who are not engaged in active business, there is a much 
stronger demand for these shares than for those which are 
paying irregular dividends. Out of two issues of common 
stock otherwise equivalent, one of which is paying a permanent 
dividend rate year after year and the other of which is paying 
dividends irregularly but averaging at least as high as the 
regular payer, the first-named issue will always sell at a sub- 
stantially higher price. For this reason, the corporation which 
has succeeded over a period of years in maintaining a record 
of dividend stability, and which has not changed and is not 
likely to change its dividend except to raise it to a permanently 
higher level, enjoys the benefit of a credit and of a demand 
for its securities which is worth a large amount of money. 

For both these reasons, even the smaller corporations are 
tending more and more strongly toward so adjusting their 
affairs that regularity — or at least approximate regularity — 
of their dividend rates can be attained. It is coming to be 
more and more widely recognized by bankers, investors, and 
the public at large, that the ability of a company to maintain 
regular rates is a better test of its soundness than is its ability 
to pay high but irregular dividends. 

Variability of Profits 

In sharp contrast to the desired regularity of dividend 
payments is the wide fluctuation in profits that is characteristic 
of the majority of corporations. Business does not move on 
a regular and even keel. Economic and financial conditions 
vary ; changes in management occur ; difficulties with employees 
arise; changes in taste may suddenly create new markets or 
wipe out markets — all these and many other factors which are 
constantly at work bring about kaleidoscopic changes which 



DIVIDENDS 443 

often come as great surprises even to people who are intimately 
acquainted with the business. The sudden outbreak of the 
European War in 19 14, followed by an intense depreciation 
in iron and steel and machinery industries, was an unexpected 
variation of this kind. Within a few months it was followed 
by an unprecedented demand from the European nations at 
war for the products of American farms and factories, stimu- 
lating production and prices to an unheard-of extent ; this was 
a variation no less surprising. It is not necessary, however, 
to cite the extraordinary conditions produced by the European 
War. 

Rapid fluctuations are constantly taking place even under 
normal conditions. During the fiscal year 19 13, the Lacka- 
wanna Steel Company earned over $3,000,000 available for 
dividends on its common stock, equal to 8.3 ; in the fiscal year 
1 9 14, prior to the outbreak of the European War, the same 
company showed a deficit, after payment of fixed charges, 
amounting to $1,500,000. The experience of the Mount 
Vernon- Woodberry Cotton Duck Company after its formation 
is typical of sudden fluctuations that are apt to occur in any 
industry. At the time the combination was formed in 1899 
there was a large demand for its product. In the first six 
months of 1900 net manufacturing profits were more than 
$750,000; in the second six months of the same year, the 
profits sank to $350,000; in the first six months of 1901 there 
was a manufacturing deficit of $200,000, to which should be 
added fixed charges of $175,000. Certain lines of business, 
such as building construction, ship construction, iron and steel 
manufacturing, and manufacturing of novelties and articles 
of fashion or luxury, are peculiarly subject to great fluctua- 
tions. In Andrew Carnegie's famous phrase these industries 
are either "prince or pauper." 

On the other hand, industries which sell small articles for 
personal use, such as cigars or household sundries, are likely 



444 



INTERNAL FINANCIAL MANAGEMENT 



to avoid fluctuation. The business of the large five-and-ten- 
cent stores is especially stable ; owing to the fact that they are 
operated on a strictly cash basis, there is usually little difficulty 
in adjusting expenditures to sales. During August and Sep- 
tember of 19 14, when almost all other lines of business were 
suffering, the business of F. W. Woolworth Company and 
S. S. Kresge Company both showed very satisfactory increases 
over the business of preceding years. 

Companies which follow the policy of protecting their cus- 
tomers and of charging prices that yield them only a moderate 
rate of profit are likely to be rewarded by being able to main- 
tain a fairly steady volume of sales and of profits. If this 
policy results in stabilizing dividends, the credit of the com- 
pany may be so much enhanced as to be of much greater value 
than any excessive profits it might have extracted from its 
customers. 

Although companies differ widely among themselves, they 
are all subject to a greater or less degree of fluctuation in their 
profits and at the same time (with the exception of the closely 
held corporations) they are all under pressure to maintain 
regular rates of dividends. How are these two conditions 
to be reconciled ? 

Rule for Maintaining Regularity of Dividend Rate 

There is obviously only one satisfactory answer — dividends 
must not be allowed to rise, even in the most prosperous 
periods, above a conservative estimate of the minimum earn- 
ings of the company. Those concerns which suffer from 
great fluctuations find this to be a harsh rule. It means that, 
so long as there remains even a reasonable possibility that 
earnings may sink close to or below the level of fixed and con- 
tingent charges, no dividends whatever should be paid. This 
has, in fact, been the rule followed by all really successful 
corporations the nature of the business of which involves un- 



DIVIDENDS 



445 



avoidable fluctuations. The Carnegie Steel Company ran as 
a highly successful corporation for many years without paying 
dividends. When Charles M. Schwab took control of the 
Bethlehem Steel Corporation in 1902 and started to build it 
up, it was on the basis of devoting all the earnings to up- 
building without paying a cent of dividends — and the policy has 
since been rigorously followed. Even after a corporation of 
this nature begins to pay dividends, it is not to be expected, 
if the management is conservative, that they will rise any- 
where near the level of the average earnings. The rule of 
keeping dividend payments below the level of minimum earn- 
ings must strictly be adhered to. 

Possibly the net result may, at first glance, seem to be a 
permanent loss to the shareholder, who can never expect on 
this principle to receive in dividends any large proportion of 
the actual earnings of their corporation. However, this loss 
is apparent, not real, for two reasons : 

1. The proportion of earnings paid out in dividends being 
small, there is a rapid increase in the productive capacity of the 
company, due to betterments provided out of surplus, and this 
increase may in the course of a few years raise even the 
minimum net earnings far above the average earnings that 
would otherwise have been received. 

2. The very fact that lines of business in which great 
fluctuations occur call for extreme patience and self-denial on 
the part of shareholders, means that comparatively few men 
are willing to put their capital and energy into getting a busi- 
ness of this nature thoroughly well established and that oppor- 
tunities for exceptionally large profits are, for this reason, 
left open. 

It is partly owing to this condition that Andrew Carnegie 
and his partners built up their wonderfully profitable iron and 
steel business. Their earnings year after year went back 
into the business, and they did not themselves realize the full 



446 INTERNAL FINANCIAL MANAGEMENT 

value of the property they had created. But when the time 
arrived for the formation of the United States Steel Corpora- 
tion, the market value of the securities that went to the 
Carnegie Company was well over $500,000,000. The same 
rule could be applied with even less question and more rigor 
to those corporations which conduct a comparatively stable 
business. For them it is only a minor hardship to keep divi- 
dend payments below the level of minimum earnings. This 
regularity of dividend payments results in a gain in credit 
that is secured with relatively little sacrifice. 

Policies of Important Companies 

Taking a few examples first of regularity of dividends, we 
have such records as that of the American Express Company, 
which paid regular dividends every year from 1882 to 1901 
of 6% ; from 1901 to 1906 of 8% ; from 1906 to 1912 of 12%. 
The Mergenthaler Linotype Company, during the ten years 
1902 to 191 2, paid 10% regular dividends plus a 5% extra 
dividend each year, making 15% annually. The Perra Salt 
Manufacturing Company has paid 12% annually since 1863. 

The dividend record of the John B. Stetson Company, 
which follows, is an excellent example of stability combined 
with liberal distribution of large profits accumulated during 
the earlier years of the company's existence. It will be noted 
that after 1893 dividends were decreasing slightly, but this is 
to be explained by reason of the great depression from 1893 
to 1896 which could not reasonably have been foreseen: 

John B. Stetson Co. (Hats) 







Common Dividend Record 


1892 


6% 


1896 4% 


1893 


6% 


1897 5% 


1894 


4% 


1898 8% 


1895 


4% 


1899 12% 



DIVIDENDS 


447 


1908 


25% and 25% extra 


1909 


25% 


1910 


25% " 25% " 


1911 


25% 


1912 


25% " 25% " 


' extra 1913 


25% 


1 " I9H 


25% 


" 1915 


25% 



1900 15% 

1901 17% 

1902 17% 

1903 20% 

1904 20% 

1905 20% and 

1906 20% " 5% 

1907 20% " 5% 

The Merchants and Miners Transportation Company has 
been paying dividends at the rate of 20% since 1856. 

The dividend record on the common stock of the Proctor 
and Gamble Company, manufacturers of soap, has been as 
follows : 

1891 8% 

1892-1897 12% per annum 
1 898- 1 900 20% per annum 
1901-1913 12% per annum 

1913-1915 16% per annum plus a 4% common stock 

dividend 

The apparent decrease in dividends, beginning in 1901, 
was due purely to the fact that in December, 1900, the out- 
standing issue of common stock was doubled by a 100% stock 
dividend. In reality, therefore, the new dividend of 12% 
was equivalent to a dividend of 24% on the former issue. In 
addition to the regular dividend, the company paid an extra 
dividend of 14.2% in January, 1904, and another extra divi- 
dend of 25% in December, 1905. 

The Eastman Kodak Company has paid regular 10% divi- 
dends since 1902, but with extra dividends in most years 
running from as low as 9^% to as high as 30%. These 
extra dividends are so high that they overshadow the regular 
dividends, and, if any criticism of so successful an enterprise 
is permissible, it may be based on the desirability of attaining 
a greater degree of regularity in the extra as well as in the 
so-called "regular" disbursements. 



4 4 g I&TERfrAL FINANCIAL MANAGEMENT 

On the other hand, concerns engaged in fluctuating lines 
of business, frequently decline to restrict themselves to the 
payment of a fixed dividend rate. The dividends of the Amal- 
gamated Copper Company from 1899 to 191 2, ranged from 
1/4% to 7^2%, and of the Anaconda Copper Company from 
as low as 3% in 19 13 to 26% in 1907. There is less excuse 
in the case of the American Thread Company, the business of 
which is relatively stable; nevertheless from 1902 to 19 12, 
dividends varied from as low as 4% to as high as 16%. The 
Bourne Mills between 1897 and 191 2 paid dividends which 
fluctuated from as low as 3% to as high as 49^%. 

Following is the record of the Porto Rican American To- 
bacco Company, which is even more remarkable for the extent 
and rapidity of its fluctuations : 



1904 


8 % 


1905 


3i^% 


1906 


84 % 


1907 


io}4% 


1908 


5 % 


1909 


9 % 


1910 


14 % 


1911 


16 % 


1912 


16 % plus 20% (scrip) 


1913 


20 % (scrip) 


1914 


20 % (scrip) 


i9 J 5 


8 % plus 5% (scrip) 



The Atlantic Refining Company, like various companies 
of the oil and other extractive industries, prefers to allow its 
dividends to fluctuate with its profits. Before the disintegra- 
tion of the Standard Oil Company it was customary for the 
directors to make up their minds at the end of each quarter 
what rate of dividend for the quarter should be declared. In 
this case the fact that the company, although of enormous ex- 
tent, was comparatively closely held, was no doubt another 
reason for following the practice. 



DIVIDENDS 449 

From companies engaged in extractive industries come the 
most remarkable records of enormous profits, and it is perhaps 
natural that the desirability of stability in their dividend 
disbursements should not appeal to them as of great impor- 
tance. The Calumet & Hecla Mining Company, which has 
outstanding about $2,500,000 of capital stock with a par value 
of $25, of which only $12 per share is paid up, has paid out 
total dividends from 1871 to 19 13 amounting to over $121,- 
000,000. One of the largest dividend-payers was the Koloniale 
Bergbau Gesellschaft (Colonial Mining Company), a German 
concern, which operated diamond mines in German Southwest 
Africa. Its capital is only about $25,000. Its dividend record 
before the war was : 

1910 2,400% 

1911 2,500% 

i9 J 2 3>8oo% 

1913 2,500% 

Total for four years 11,200% 

That many manufacturing companies have not yet reached 
the ideal condition above described of paying regular rates 
of dividend which are never changed except to be increased, 
is shown by the record for the 18 months — January 1, 19 13 
to July 1, 19 14 — of industrial corporations the stock of which 
is listed on American stock exchanges. Forty-three of these 
companies passed their dividends; sixteen others reduced th.eir 
dividends. This took place in a period of depression, to be 
sure, but not in a period of sudden or overwhelming crisis. 

The great advantage of prudent management in the main- 
tenance of a low but regular rate of dividends is shown in the 
record during recent years of two great railroad companies. 
In 19 1 3 the earnings of the Pennsylvania Railroad Company 
fell to the lowest figures except one in fifteen years, and in 
19 14 there was a further sharp decline. Nevertheless, even at 



45o 



INTERNAL FINANCIAL MANAGEMENT 



this level the company's regular 6% dividends were not for 
a moment endangered. In 1914 and 191 5 the Canadian Paci- 
fic Railroad Company passed through a tremendous crisis 
brought on by the European War. It had been the practice 
of this company to pay a regular dividend of 7% out of operat- 
ing earnings and an additional dividend of 3% derived from 
the company's holdings of securities in subsidiary enterprises. 
Although during the year of crisis, the 7%. was not fully 
earned, income from other sources was sufficient to enable the 
company to go ahead with its regular 10% rate. 

Paying Dividends from Accumulated Surplus 

Frequently the question arises whether dividends which 
have not been earned during a given period should nevertheless 
be paid and charged against the surplus that has been accumu- 
lated in previous periods. Ordinarily the answer that should 
immediately be given is, no. In ordinary practice surplus, 
as will be more clearly emphasized in the chapter following, 
is as much a part of the permanent capital of a company as 
is the capital stock itself. It is not invested in such a form 
as to make it available for the payment of dividends and it is 
understood as a matter of course by the creditors of the com- 
pany that it represents a permanent investment. 

All this refers to customary financial practice, and not to 
the legal view of surplus which makes no distinction between 
that which has been accumulated in the past and that which 
is current. The legality of paying dividends out of accumu- 
lated surplus, which has seldom been seriously questioned, was 
reaffirmed in the New York courts in 19 14 in an action brought 
by the preferred shareholders of the Union Pacific Railroad 
Company to enjoin the distribution of certain shares of 
stock and amounts of cash held in the treasury of the com- 
pany to the common shareholders. The Union Pacific, which 
had been paying 10% per annum, desired to distribute securi- 



DIVIDENDS 451 

ties and cash which would yield 2%, and thereupon to reduce 
its regular dividend payment to 8%. Certain preferred share- 
holders objected on the ground that this extra distribution 
would be charged, not against current surplus, but against 
accumulated surplus, and that the preferred shareholders had 
acquired a vested right, as a part of their equitable interest in 
the company, to be protected by the full amount of the accumu- 
lated surplus. No legal grounds for granting the injunction 
asked for were found by the court and the action was dis- 
missed. Granting, then, that accumulated surplus is legally 
available for the payment of dividends and that customary 
practice makes it unavailable, the question still remains whether 
exceptions to this customary practice should ever be admitted. 
In July, 19 14, the directors of the Baltimore and Ohio Rail- 
road Company voted the usual semiannual dividend of 2% 
on the preferred and 3% on the common. The required total 
of dividends for the year, which amounted to $11,538,888, 
was greater than the surplus during the year by $2,469,095. 
It was explained unofficially that the company had not exer- 
cised its privilege of prorating depreciation charges over a 
series of years, but had charged against current earnings over 
$2,000,000 of losses incurred in the Central Western floods 
of March, 1913. The action of the directors was based on 
the belief that the decline in earnings was only temporary, 
and on a profound desire to maintain an unblemished record 
of regular dividends. There is no question as to the conserva- 
tism and ability of the board and this action was somewhat 
grudgingly accepted by the financial community as sound and 
correct. Nevertheless, it is by no means to be regarded as a 
precedent, but only as an isolated concession. 

Cash Requirements for Dividends 

In discussing the payment of dividends so far in this 
chapter, our attention has been concentrated, as is usually the 



452 



INTERNAL FINANCIAL MANAGEMENT 



case, on the relation between dividends and profits. It has 
been assumed that adequate and regular profits — provided they 
are correctly estimated — justify dividends. But this assump- 
tion must not be permitted to stand longer unchallenged. It 
is, in fact, the direct source of a large proportion of financial 
embarrassments. Thousands of corporations which have been 
able to report highly satisfactory profits and which have paid 
good dividends on the strength of those profits, have found 
themselves a short time later — to the intense surprise and in- 
dignation of their stockholders and even of their directors 
and officers — in the hands of their creditors. It is quite ap- 
parent that many business men, even including some of unusual 
capabilities, do not fully grasp the fact that dividend pay- 
ments should be dependent not only upon profits, but also upon 
the corporation's cash position. 

The point has already been emphasized and will later be 
reiterated, that many companies find their chief financial diffi- 
culties arising not in periods of depression and small business, 
but in their periods of prosperity. To attempt to do a large 
volume of business with a small working capital is one of the 
quickest and surest methods of financial hari-kari. Yet this is 
precisely the course that is followed by those concerns which, 
on the strength of a showing of profits, declare dividends, the 
payment of which seriously depletes their working capital. 
Under these conditions the only prudent course is to withhold 
dividends until in the normal course of the company's business 
cash is accumulated beyond the requirements of the business. 
It is not merely a book surplus, but in addition a satisfactory 
cash balance, that should furnish the basis for a declaration of 
cash dividends. 

To give a concrete illustration of a situation which does 
not justify cash dividends, we may take the case of a flour 
mill company operating in Canada which has outstanding 
capital stock of $1,000,000. During a recent year the com- 



DIVIDENDS 



453 



pany reported net profits available for dividends amounting 
to $91,462, and declared dividends of $30,000, or 3%, leaving 
an addition to the surplus of $61,462. On the face of it 
there would seem to be no reasonable question as to the con- 
servatism of this small dividend declaration. When we come 
to examine the company's balance sheet after payment of the 
dividend, however, we find that it shows a secured overdraft 
at its bank of $191,000. Its cash on hand is less than $6,000, 
and its cash and receivables together are less than its current 
liabilities. A glance at this balance sheet is enough to prove 
that the payment of dividends was not merely unwise, but a 
thoroughly reckless and dangerous proceeding. 

Another example, which indicates clearly the results to 
stockholders of carelessness in figuring on cash requirements 
for dividends, is furnished by the history of the New England 
Cotton Yarn Company which was in existence from 1899 to 
1903. During these four years the company was earning suffi- 
cient profits out of which to pay preferred stock dividends and 
actually paid these dividends, amounting in the aggregate to 
$1,212,500. During the four years cash fell approximately, 
from $2,000,000 to $500,000; notes payable which had been 
at one time reduced to as low as $650,000, rose before end of 
the four years to over $2,000,000. The inevitable result was 
receivership. Without the heavy outgo of cash dividends 
this might have been avoided. Even the preferred stock- 
holders who received the dividends were heavy losers by this 
policy; although they received $24.25 a share in dividends, the 
market value of their stock went down from $105 to $25.* 

Paying Dividends with Borrowed Cash 

Sometimes circumstances arise which justify the directors 
of a corporation, in their opinion, in borrowing the money 
with which to pay dividends. This is, in fact, quite frequently 

*Dewing's "Corporate Promotions and Reorganizations," p. 324. 



454 



INTERNAL FINANCIAL MANAGEMENT 



the case with companies which have to contend with wide 
seasonal fluctuations and with companies which normally oper- 
ate with a small working capital. As has previously been 
pointed out, transportation and communication enterprises 
frequently belong in this last-named group. Commenting on 
numerous cuts in the dividends of railway corporations, the 
London Financial Times of October 2, 19 14, says editorially: 

It is necessary to be guided by the amount of cash 
actually in the till. Borrowing on temporary loans from 
one's bankers in order to make up the heavy amount of 
ready cash required to pay dividends — a common and 
perfectly proper procedure in normal times — is much 
less desirable under existing financial conditions. 

For companies of the two types just referred to, it may be 
sound policy at times to pay dividends with the proceeds of 
temporary bank loans— assuming, of course, that there can 
be no reasonable question as to the company's ability to repay 
these loans without crippling itself. There is a great distinc- 
tion, however, between this situation and that which exists 
when a corporation issues long-term obligations or when it 
sells additional stock in order to obtain money with which 
to pay dividends. If a corporation were to follow this prac- 
tice during a period when it was not actually making a legiti- 
mate showing of profits, it would be clearly engaged in a 
fraudulent transaction. When it issues long-term obligations 
or sells additional stock during a period of adequate profits or 
for the purpose of paying dividends that are charged against 
accumulated surplus, its course of action is not necessarily 
fraudulent, but it is certainly open to serious question as to its 
essential soundness. 

A case which aroused a great deal of discussion in financial 
circles occurred in 19 13, when the management of the Ameri- 
can Can Company decided that the time had arrived when 
it was advisable to pay up a portion of the dividend claims 



DIVIDENDS 



455 



on its preferred stock issue which had been accumulating over 
a period of several years. The company sold an issue of 
$14,000,000 5% debenture bonds and with the cash proceeds 
paid a 24% dividend on preferred stock. The consensus of 
opinion among conservative judges, it may safely be said, was 
that it would have been far wiser to have paid off the arrears 
of preferred dividends gradually out of profits as they accumu- 
lated. Although it is true that this plan would have involved 
deferring common dividends for a period of years, it would 
have put the company eventually into a position of undoubted 
financial strength. 

Effects of Lack of Prudence in Paying Dividends 

It seems almost superfluous, after what has been said above, 
to cite examples of financial difficulties which are traceable to 
the payment of dividends which were not earned or which 
could not be met without reducing working capital below the 
limits of safety. The number of examples is practically in- 
finite. Some of the most flagrant are furnished by the records 
of important industrial combinations. Following is a self-ex- 
planatory extract from a review published in the London 
Statist of October 17, 1914: 

The evil result of continually paying out the earnings 
of a company — and perhaps a little more — may be illus- 
trated from the experience of Dick, Kerr and Co. The 
annual net trading profits of this company for a series 
of years has been as follows: 

1909 £28,168 

1910 22,821 

!9U 37>994 

1912 3,275 

J 9i3 30,092 

I9 X 4 • • 44,762 

On the whole, the net profits show a favorable ten- 
dency toward increase, although this is strikingly inter- 



456 INTERNAL FINANCIAL MANAGEMENT 

rupted by the bad year, 1912. In 1909-10-11, the company 
paid in addition to its full debenture interest, preference 
dividends amounting to £18,300 and ordinary dividends 
amounting to £13,000, leaving annual deficits as follows: 

1909 • £18,425 

1910 20,884 

19" 5>366 

In 1912, the ordinary dividends were cut off and have 
not since been resumed, but the preference dividends 
were continued with the result that in that year a deficit 
was still shown of £26,876. In the following year there 
was a surplus of £309, and in 1914, a surplus of £15,201. 
On October 15, 1914, the preference shareholders gave 
their consent to the issue of additional debenture stock. 
It was stated that the company's cash resources have been 
greatly depleted by the redemption of existing debentures 
and at the same time the. need for working capital has 
increased. "For some time past, temporary accommoda- 
tion has been obtained from the company's bankers or 
others." 

As to the record of American industrial combinations, we 
cannot do better than present the following abstract from the 
conclusions ably stated in Dewing's "Corporate Promotions 
and Reorganizations." 

Nearly all the large industrial combinations have been 
guilty of distributing dividends recklessly. This is due 
in part to the extravagant promises on the strength of 
which securities have been sold, in part to the optimism 
of promoters and directors, in part to a desire to unload 
on the part of many of the insiders. 

The failures of the Corn Products Co., The American 
Malting Company, the U. S. Realty Co. and the New 
England Cotton Yarns Co. were the direct results of un- 
warranted payments of dividends. The U. S. Leather 
Co., the National Cordage Co., the National Salt Co., the 
Consolidated Cotton Duck Co., and the International Cot- 



DIVIDENDS 

ton Mills Corporation, were all seriously weakened by 
payment of dividends at the expense of their cash posi- 
tion. 

In the case of the American Malting Co., it was 
proved that the directors must have declared dividends 
without having- before them any statements of earnings. 
This same thing probably is true also of other cor- 
porations. 

The great fluctuations in industrial earnings are the 
chief argument against the use of bonds by industrials 
and in favor of conservatism in paying dividends. In 
1908 the Westinghouse Co. had gross sales of $20,000,000 
and a deficit of $1,000,000. In 1909, gross sales of 
$30,000,000 and net profit of $3,000,000. 

These fluctuations involve a strong tendency to bor- 
row on short-term notes or even to use short-term notes 
as a means of raising money with which to pay dividends. 

There is sound reason for borrowing on short time in 
order to meet fixed charges inasmuch as the insolvency 
and reorganization of the company, even though it be 
only temporary, involves a severe blow to its credit and 
trade. For instance, after the panic of 1907, the General 
Electric Co. had a loss of 25% in its business and the 
Westinghouse Co. 37%. The explanation seems to be in 
the failure of the Westinghouse Co. 

The fact that insufficient working capital exists at the 
time of the insolvency of a company is not proof that 
this is the actual cause of insolvency. It is very often 
true that the lack of working capital is itself due to un- 
wise payments on account of fixed charges and on ac- 
count of dividends. 

The only possible reasons which can lead directors 
to pay out unearned dividends are: 

1. Ignorance. 

2. A false belief in the immediate return of 

prosperity. 

3. A desire to give the corporation a higher stand- 

ing in the stock market, or with creditors, than 
its earnings warrant. 



457 



45 8 INTERNAL FINANCIAL MANAGEMENT 

Scrip Dividends 

Scrip dividends are those which are issued in the form of 
promises to pay on the part of the corporation. These prom- 
ises may or may not bear interest. They usually mature at 
some definite date, but may be purely indefinite I. O. U.'s, 
redeemable at the option of the corporation or redeemable 
within a certain limit of time. They are intended usually to 
meet the situation which has been briefly described above — 
that of a corporation which has made a good showing of profits 
during a given period, but is not in sufficiently strong financial 
position to part with cash. Payment of dividends in scrip is 
sometimes voted in order to avoid spoiling a dividend record 
that would otherwise be unbroken or as a temporary expedient 
to keep up dividends on preferred stock. After the first West- 
inghouse reorganization in 1891, the first dividend of 1%% 
on the preferred stock was issued in scrip, so as not to reduce 
the working capital immediately. In October, 19 14, the Cam- 
bria Steel Company desired to keep up its regular 5% divi- 
dends, but, on account of the European War, the directors 
did not think it wise to pay out in cash the $562,500 required. 
On account of the dull state of trade, inventories were larger 
than usual, and available cash resources were smaller than 
usual. The directors solved the difficulty by issuing a scrip 
dividend bearing 5% interest. In 1910 the Crucible Steel 
Company of America took care of a portion of the accumulated 
dividends on its preferred shares by paying 10% on these 
shares in the form of scrip bearing 3% interest. 

In 1 88 1 Henry Villard after a considerable struggle ob- 
tained control of the Northern Pacific Railroad. In the course 
of his fight for control he had advocated the payment of divi- 
dends on the company's preferred stock, and in the first annual 
report after his election as president it was stated that the 
surplus earnings since 1875, amounting to $4,667,490, had 
been used for construction and were properly due to the pre- 



DIVIDENDS 



459 



ferred stockholders. On the strength of his statement, the 
directors declared a dividend to the preferred stockholders 
of n%, which was not paid in cash but in the form of 5-year 
6% obligations of the company redeemable after one year at 
the option of the company. When this scrip fell due in 1887, 
the company was in no condition to pay it in cash. It there- 
fore imposed on its property a third mortgage amounting to 
$12,000,000, over $3,000,000 of which was used to meet the 
maturing dividend scrip.* 

The payment of accumulated dividends on preferred shares 
has been, in a number of cases, taken care of in this manner. 
The Trenton Potteries Company has outstanding $411,570 of 
"funding certificates" which were issued to stockholders who 
exchanged their 8% cumulative preferred for a new issue of 
8% non-cumulative preferred. These stockholders received 
44%, being the amount of their dividends in arrears, in the 
form of "funding certificates. ,, 

Stock Dividends 

A form of dividend payment which appears to be growing 
in popularity is the issuance of stock representing profits not 
otherwise distributed. Stock dividends are issued for any of 
three reasons : 

1. In order to give to stockholders tangible evidence of 

the increasing value of their property. 

2. In order to maintain the market value of the stock 

at a price which will make it more readily market- 
able. 

3. In order to veil huge profits in prospect by making 

it possible to declare a small or moderate dividend 
on a large amount of stock instead of a very high 
dividend on a small amount of stock. 



'Daggett's "Railroad Reorganizations," pp. 274-276. 



4 6o INTERNAL FINANCIAL MANAGEMENT 

These three motives are not always clearly distinguished; 
one of the three is usually predominant. It will be agreed by 
everyone that the payment of a stock dividend does not in 
itself add anything to the assets of the stockholders who re- 
ceive the dividend. If the owner of one share of stock in a 
corporation with $100,000 stock outstanding, is given, we will 
say, a 900% stock dividend, so that he becomes the owner 
of 10 shares in a $1,000,000 corporation, his real standing 
has not been changed in the slightest. He remains, just as he 
was at the beginning, the owner of 1/1,000 interest in the 
enterprise. His only real gain comes in the mental satisfac- 
tion that he receives if he continues to hold his stock indefi- 
nitely (and this is by no means a negligible factor), or in the 
easier marketability of his holdings if he wishes to sell them. 
Even the third motive does not affect the shareholder's income 
but merely the nominal rate of dividend on his holdings. 

A clear illustration of the predominance of the first motive 
is to be found in the recent announcement of a 10% stock 
dividend on the part of the Corporation of Riker and Hege- 
man, a company which owns a chain of drug stores which is 
controlled by interests associated with the United Cigar Stores 
Company. During the process of building up this last-named 
company, no cash dividends were declared but the increasing 
surplus was represented by frequent declarations of stock divi- 
dends. A number of other companies have adopted the prac- 
tice of paying regular stock dividends in addition to cash 
bonuses. The annual 4% stock dividends of the Proctor and 
Gamble Company have been referred to. The American Light 
and Traction Company has for several years declared regular 
quarterly dividends of 2 J / 2 % in cash and 2^% in stock. The 
United Light and Railways Company is paying quarterly 
dividends of 1% in common stock. The American Gas and 
Electric Company and the City Service Company have also 
paid small stock dividends. It may be assumed that the 



DIVIDENDS 



461 



practice in the case of public utility companies has in view 
the desirability of keeping down the rate of cash dividends 
to a moderate amount. Much the same plan has been followed 
by some of the English public utility companies. 

Stock dividends which are intended to represent large 
accumulations of surplus that could not be disbursed in cash 
have been especially frequent of late years among automobile 
companies. The Packard Motor Company is said to have 
paid no cash dividends on its common stock, which is closely 
held, but did pay in 1913 a 40% stock dividend on its $5,000,- 
000 common previously outstanding, bringing that issue up 
to $7,000,000. The General Motors Company not long ago 
declared 150% stock dividend. The record among motor 
companies up to the present time is held by the Chalmers 
Company, which in 19 10 paid a stock dividend of 900%. 
Even this record, however, is likely to be overshadowed by the 
action on the part of the Ford Motor Company, which has 
been announced but not yet put into effect, providing for a 
stock dividend of 2,400% with a view to raising its outstand- 
ing capital stock from $2,000,000 to $50,000,000. 

The record of the Singer Sewing Machine Company, with 
its various stock dividends of 100 and 200%, has been pre- 
viously mentioned. Other instances are those of the Pabst 
Brewing Company, which paid out an issue of $2,000,000 7% 
cumulative preferred in the form of a 20% stock dividend to 
its common stockholders; the Pacific Mills, which increased its 
capital stock from $3,000,000 to $12,000,000 by the declara- 
tion of a 300% stock dividend, at the same time reducing the 
par value of its shares from $1,000 to $100; the American 
Rolling Mills Company, which paid a stock dividend of 
33 l /3% m l 9°7 an< 3 another stock dividend of 100% in 1909; 
the Adams Express Company which in 1907 paid a special 
dividend in the form of 4% collateral trust bonds; the George 
E. Keith Company, which in 19 13 issued $4,000,000 7%. cumu- 



4 6 2 INTERNAL FINANCIAL MANAGEMENT 

lative preferred as a 200% stock dividend; and the Midvale 
Steel Company which in 1910 declared a 1,200% stock divi- 
dend increasing the outstanding issue from $750,000 to 
$9,750,000. 

It should be remarked at this point that the issuance of 
preferred stock or of bonds in payment of dividends is a device 
that may be regarded as in one sense actually increasing the 
property interests of each stockholder. Yet, after all, each 
shareholder is lifting himself by his own boot-straps ; whatever 
he gains in the form of a prior claim for interest or preferred 
dividends, he has gained at the expense of his common share- 
holdings which are thereby reduced to a correspondingly lower 
level. Even in these instances, therefore, the statement that 
a stock dividend does not in itself change the real value of a 
stock owner's holdings is substantially correct. The effect 
of an increase in stock which tends to reduce the market value 
of each share and thereby to make it more readily marketable, 
has been discussed in earlier chapters. It is sufficient here to 
give one illustration. 

In 1892 the National Cordage Company, which had been 
organized in 1887, was at the height of its prosperity and its 
stock was one of the leading securities on the New York Stock 
Exchange. In the autumn of that year, a member of the Ex- 
change remarked to President Waterbury, "Your stock is 
selling too high," meaning that for speculative purposes it 
would be better to have the stock selling at $70 a share rather 
than at $140. President Waterbury presented the idea to the 
board of directors who decided to issue in January, 1893, a 
100% stock dividend. The book value of the subsidiary plants 
was marked up to correspond with the inflation of the capital 
stock. Through the payment of the dividend the outstanding 
stock was increased from $10,000,000 to $20,000,000. The 
directors explained that the new issue was "to represent about 
$10,000,000 of assets acquired by the company since its forma- 



DIVIDENDS 



463 



tion, and which it is the policy of the company to hold intact." 
The directors also stated that it would be the company's policy 
to pay dividends of 7% on the new common stock. A little 
over a year later the company was in the hands of receivers.* 

Legal Rules Affecting Dividends 

It would be inadvisable to close this chapter without calling 
attention to some well-established legal principles which should 
always be kept in view. Perhaps the most important of these 
principles is that dividends shall be paid only out of surplus 
and never out of capital. The Corporation Act of New Jersey 
provides that directors who take part in such action, or who 
do not enter a protest within a reasonable period, shall be 
personally liable during a period of six years following the 
payment of such dividends. The best-known case which has 
established and emphasized this principle is that of the 
American Malting Company. During the first year of the 
existence of this company the directors declared cash dividends, 
apparently on the strength of "anticipated" profits which were 
included in the income account. After the facts became 
known, suits were brought by stockholders both in New York 
and New Jersey, and in both states the suits were decided in 
favor of the stockholders. After litigation lasting almost five 
years, the matter was settled by the payment on the part of 
individual directors of $500,000, $340,000 of which went into 
the treasury of the company and $160,000 to the plaintiffs for 
the expenses of their suits. 

Another important legal principle is that dividends once 
declared become an indebtedness of the corporation to the 
stockholders and cannot afterward be rescinded by the direc- 
tors. It is even held in most jurisdictions that dividends once 
declared no longer belong to the corporation but have become 
the property of the stockholders as individuals. 

•Dewing's "Corporate Promotions and Reorganizations, p. 132. 



464 INTERNAL FINANCIAL MANAGEMENT 

There are numerous special requirements and limitations 
contained in the constitutions of the various states. As an 
example, attention may be called to a law in the State of 
Massachusetts forbidding the issuance of stock and scrip divi- 
dends by public utility companies, which reads as follows : 

No company shall declare any stock or scrip dividend 
or divide the proceeds of any sale of stock or scrip 
among its stockholders; nor shall any company create 
any additional new stock or issue certificates thereof to 
. any person unless the par value of the share so issued is 
first paid in cash into its treasury. 



CHAPTER XX 

SURPLUS 

Surplus Reserve and Surplus Fund 

The final item in our formula for income consists of 
"balance carried to the permanent surplus account." It is 
sometimes labeled "surplus for the period," but, inasmuch as 
this phrase is applied also to what we have called "balance 
applicable to dividends and surplus," it is somewhat misleading 
and for this reason is not used. Much confusion of thought 
arises out of the continual inaccuracies and variations in the 
application of such terms as "income," "profits," "earnings," 
and "surplus." Until the general usage of this and many other 
business terms becomes more clearly settled, it will be impos- 
sible wholly to avoid this confusion. 

Two terms which should be clearly distinguished, however, 
are "surplus reserve" and "surplus fund." Surplus reserve, 
more frequently referred to simply as "surplus," is in effect 
simply an account or a group of accounts kept in the company's 
books which show the va lue of the e quity belonging to stock- 
holders over and above the par value of the outstanding shares. 
Like many other accounts, surplus is in part the result of esti- 
mate or of a series of estimates. If the estimate is judged 
by the directors or officers of the corporation to be wrong, it 
may be changed by a mere entry in the company's journal. 
An instance has been cited in the preceding chapter of the 
marking up of the book value of the plants and other assets 
of the National Cordage Company by $10,000,000, in order 
to create on the credit side of the balance sheet an increase in 
the surplus account of $10,000,000 from which a stock dividend 
could be paid. An instance has previously been given also of 

465 



466 INTERNAL FINANCIAL MANAGEMENT 

a publishing company, the good-will account of which was 
increased by $300,000 in order to inflate the surplus account 
by a like amount. In the section following, the various methods 
through which a surplus account may be built up are reviewed. 
For the immediate purpose, it is sufficient to emphasize the 
point that surplus reserve is in itself purely a more or less 
formal and inconclusive appraisal of the shareholders' equitable 
interest in the corporation above the par value of their hold- 
ings. 

A surplus fund, on the other hand, is an asset account 
which can be properly used only to designate certain sums of 
cash, of securities, or of other property, which are set aside, 
not for use within the business, but for some supplementary 
purpose such as the retirement of certain securities or for the 
general protection and insurance of the shareholders against 
loss.) The surplus fund seldom exists in this country under 
this title. It not infrequently happens, however, that a com- 
pany carries holdings of cash or securities not needed in its 
business and set aside for a special purpose which could 
properly be labeled "surplus fund/' if it were so desired. 
Surplus reserve and surplus fund, even where they coexist, 
are by no means necessarily equivalent. 

In this volume, and in customary usage, the word "surplus" 
when used alone without qualification, refers to surplus reserve. 
The fact that it refers to a credit account — for which the 
corporation is responsible to its shareholders — and not to an 
asset or to any group of assets, should be borne clearly in 
mind. 

Five Sources of Surplus 

We have spoken of surplus in the preceding chapter as 
if it were always derived from earnings. Ordinarily this is 
so but surplus may result from other causes as well. Five 
possible sources of surplus are given below : 



SURPLUS 467 

1. Inheritance from previously absorbed corporations. 

2. Sale of securities above par. 

3. Sale of assets above their book value. 

4. Revaluation of assets. 

5. Accumulation out of earnings. 

The first source is uncommon, inasmuch as most new cor- 
porations, even those which take over going businesses, carry 
the assets which they acquire at their full cost value — no more 
and no less — so that they start with neither a surplus nor a. 
deficit; and this would seem ordinarily to be the correct pro- 
cedure. However, there are occasional exceptions. In 1914 
the Dominion Linens Company of Canada was organized with 
an issued capital stock of $250,000. The company, according 
to a statement prepared by the well-known accounting firm 
of Price, Waterhouse and Company, showed assets of $267,- 
684. After deducting a small amount of accounts payable 
there was left a surplus at the outset of $14,138. It should 
be remarked, however, that among the assets was one item of 
"good-will, trade-marks, etc./' valued at $20,000. A surplus 
of this nature can hardly escape the suspicion of being more 
or less fictitious. It is scarcely safe to assume that the assets 
acquired are worth more than what was paid for them. The fact 
that these assets may have been carried on the books of the 
previously existing companies at a higher book value than was 
paid for them, has no bearing on the case so far as the new 
company is concerned. 

The second source consists of the sale of securities above 
par. In such a case the corporation receives a greater sum 
than the nominal value of the obligations or the shares which 
it issues. This additional sum may be carried to an account 
called "Premium on Securities" or some such title, or it 
may be and frequently is credited direct to surplus. It is clear 
that a surplus which arises in this form is hardly to be regarded 



4 68 INTERNAL FINANCIAL MANAGEMENT 

as a proper source of dividends, inasmuch as the premium on 
shares or bonds is in reality a contribution to the capital assets 
of the company. In handling transactions of this type, in- 
dustrial and railroad corporations might profitably take a leaf 
from the practice of banks. In organizing new banks it is 
frequently agreed that every $100 share shall be sold at $125 
or $150, or some other amount above its nominal value, so as 
to create a surplus account at the outset. As the bank earns 
profits, these are carried, not to the Surplus account, but to 
an account entitled "Undivided Profits" out of which dividends 
are declared. From time to time the directors may, more or 
less arbitrarily, transfer whatever sums they decide upon from 
the Undivided Profits account to the Surplus account. It is 
understood that credits to surplus are not intended to be dis- 
tributed, but are regarded as an integral part of the permanent 
capital of the institution. 

The third source is through the sale of permanent assets, 
which are not intended for trading purposes, for a sum above 
their book value. Frequently assets are written down over 
a long period until their book valuation becomes only a small 
portion of their real value. To take an extreme and notable 
instance, the immensely valuable property of the Bank of 
England on Threadneedle Street, London, does not appear on 
the balance sheet of the corporation at all. 

The fourth source of surplus is the revaluation of assets 
which have not been sold but are intended to be retained. This 
is a tempting expedient for a company which is running at an 
operating loss or with very small profits, and yet is under 
pressure to make a satisfactory showing. In the latter part 
of 1902, the management of the United States Leather Com- 
pany decided to reappraise certain large areas of hemlock bark 
land which had been bought at a fair market valuation in 
1893. Since then prices of timber and of bark had gone up. 
A committee of directors reported in 1903 that the bark 



SURPLUS 469 

property was worth about $14,000,000 more than its book 
value. In order to show this increased value on the books, 
the officials incorporated the Central Pennsylvania Lumber 
Company (all of the stock of which was owned by the United 
States Leather Company) ; the lumber company bought the 
timber (only) on the revalued bark land, for which it gave 
$10,000,000 of first mortgage bonds. It was intended to pay 
dividends on the preferred stock out of this suddenly acquired 
surplus. However, the original contract between the corpora- 
tion and its preferred shareholders stated that dividends should 
be paid only out of net earnings, and the revaluation of the 
timber lands could hardly be construed as "net earnings." On 
the other hand, it was argued that the timber had actually 
been sold and securities had been received in payment. In 
the end, the question was settled without bringing before the 
court the dispute as to whether the formation of the subsid- 
iary company and the transfer of its bonds was or was not 
merely a fiction. 

The handling of timber properties so as to present a fair 
Statement of the results that are actually achieved, always 
raises difficult questions. Taxes assessed against timber lands 
are frequently charged into an asset account in order to show 
the total carrying charges of the property. The continual rise 
in land values, and especially in the values of timber proper- 
ties, has been so regular that this method has seldom been 
found disappointing. As to the revaluation of timber proper- 
ties, it is thought by some authorities that there is no special 
objection in this case, provided the surplus thus created is put 
into a separate account and not treated as a part of the general 
surplus available for dividends. 

The question as to whether assets should be revalued or 
not frequently arises, also, in the cases of banks and other 
financial institutions which own large amounts of securities. 
On a rising market these securities may frequently have a 



47o 



INTERNAL FINANCIAL MANAGEMENT 



market value much higher than their original cost, and the 
officers or directors of the company may desire that this extra 
value should be shown on the books and credited to surplus. 
Independent accountants are usually strongly averse to this 
practice, on the ground that it makes a fictitious showing of 
profits. If the securities are actually sold and a profit is 
realized, then this profit will naturally go into a surplus 
account. Otherwise it is regarded as sound and correct to 
carry them at their cost valuation. It is not, however, incon- 
sistent with this principle to insist that declinations in market 
value should be written off against surplus. 

It must be remembered that the surplus account is at best 
only an estimate and that it is highly desirable to keep this 
estimate always well within conservative limits. In operating 
an enterprise and selling its products, a valuable trait is the 
optimism that will carry a man forward through discourage- 
ments and temporary defeats. But in estimating the results 
and forecasting the future, it is necessary above all to be 
cautious and even skeptical. 

In general it is safe to say that the instances in which an 
upward revaluation of the permanent assets of a company is 
permissible, are highly exceptional and that in these excep- 
tional cases the surplus thus created should always be plainly 
earmarked so that there will be no mistaking its source. 

The fifth and most important source of surplus consists 
of savings out of the company's earnings. We have already 
seen that every year should yield a balance of profits above all 
fixed charges and above all dividends. This balance, if credited 
to surplus year after year, will in time build up a large surplus 
account. If the building up of this account is accompanied 
by consistent writing down of all assets of doubtful value, the 
balance sheet of the company will in time show an increasing 
equity on the part of the shareholders of a very substantial 
nature. If surplus were always built up only out of con- 



SURPLUS 



471 



servatively estimated earnings, it could be safely accepted as 
a fairly accurate measure of the real prosperity and solidity 
of the business. But surplus which comes from the other 
sources that have been named — even though it may be a 
genuine surplus which has been realized — gives no convincing 
evidence of earning power or of conservative and level-headed 
management. 

The term "surplus," therefore, in itself means little. It 
should always be examined with care and its origin should be 
determined before basing upon it any judgment as to the pros- 
perity or good management of the company which shows it. 

We have now to consider what principles should be fol- 
lowed in accumulating surplus out of earnings and what uses 
should be made of the increased assets which are represented 
in the surplus account. 

Accumulating Surplus 

In discussing the desirability of establishing and maintain- 
ing a regular rate of dividends it has been suggested that the 
only safe principle to follow is to fix the dividend rate below 
the estimated minimum earnings, thus making sure that it will 
be kept up year after year. This leaves all the extra profits 
of good years to go into surplus. If the company's business 
is of a highly stable nature so that the fluctuations in earnings 
are slight, it follows that the extra earnings of the good years 
will be relatively small and surplus will accumulate slowly. If 
the business, on the other hand, fluctuates a great deal, these 
dividends will absorb only a small proportion of average earn- 
ings, and the greater portion will remain as a credit to the 
surplus account. 

This principle, therefore, automatically results in piling 
up a surplus almost in direct proportion to the degree of fluc- 
tuation of earnings. And this is as it should be. A company 
engaged in a business which enjoys steady earnings will have 



472 



INTERNAL FINANCIAL MANAGEMENT 



no trouble in raising fresh capital for any extensions that may 
be required and which can be shown to be clearly profitable. 
It is not necessary, therefore, that new capital should be 
provided by savings out of earnings. On the other hand, a 
company, the earnings of which fluctuate widely, is, on the face 
of it, engaged in a speculative business and cannot easily secure 
fresh capital on favorable terms. Only through accumulations 
out of earnings can the business be extended and stabilized. 

The principle that has just been stated is, of course, put 
forward only as a general rule which is subject to innumerable 
qualifications and exceptions. First of all, it may be impossible 
to determine in advance what the minimum earnings are likely 
to be. Second, it may be desirable to use some discretion and 
diplomacy in dealing with stockholders and to satisfy their 
wishes from time to time by distributing a portion of the extra 
earnings of prosperous years. For both these reasons the 
strict and inflexible application of the rule that has been stated 
is not always to be insisted upon. Most well-managed 
companies are satisfied if they reach some reasonable 
approximation in applying the rule. 

There is another qualification, also, of still greater im- 
portance. In all that has been said as to this rule, it has been 
taken for granted that fresh capital can be taken into any 
business enterprise and used as profitably as the original 
capital. In a great many cases this is true, especially if the 
fresh capital is not dumped upon the company in one or two 
big lots secured through the sale of securities, but is gradually 
added year after year and thus made available for betterments 
and extensions that are actually needed. However, even in 
those cases there may, after a time, come a limit to the de- 
velopment of the company beyond which fresh capital cannot 
be profitably applied. When this limit is reached, it is no 
longer desirable to accumulate surplus with rapidity. If earn- 
ings have not at that time been stabilized, it may be good policy 



SURPLUS 473 

to pay out most of the income year after year in dividends, 
allowing the dividends to fluctuate in close relation to the in- 
come. Or it may be adjudged better to fix the dividend rate 
at about the average anticipated income, in which case extra 
profits of the good years will be invested outside the company 
in short-term securities which will be sold when necessary in 
order to provide cash or dividends during the lean years. It 
is perhaps due to the fact that opportunities for expansion of 
most successful enterprises in the United States are almost 
unlimited, that so much emphasis has been laid in our financial 
practice on the necessity of making large savings out of annual 
profits; whereas in European countries, where the oppor- 
tunities for expansion are more limited, the custom prevails 
of paying out most of the annual earnings in dividends and of 
relying upon fresh issues of securities to provide whatever 
new capital is needed. 

Policies of Various Companies 

In connection with the preceding section, the Hendee Manu- 
facturing Company may be cited as a typical example of 
American practice; this is a relatively small but prosperous, 
rapidly growing, and evidently well-managed corporation, 
which specializes in the production of motor-cycles. In the 
year ended August 31, 19 14, this company earned profits of 
$711,566, out of which it paid dividends of only $131,250; a 
sinking fund of $150,000 for the retirement of preferred 
stock was also deducted, leaving the amount of profits for the 
year carried into the surplus account, $430,316. 

By way of contrast we may take at random a well-known 
and well-managed English company — Harrison and Cros- 
field, Limited — which has been earning profits of about the 
same amount as the Hendee Company. During the four years 
1910-1914 net profits averaged about £150,000, from which 
have been normally deducted : 



474 INTERNAL FINANCIAL MANAGEMENT 

Dividends on $ J A% cumulative preferred shares. £27,500 
Dividends on the 10% preferred ordinary shares. £30,000 

Dividends on management shares £30,000 to £67,500 

Approximate remaining balance £60,000 to £25,000 

However, this balance is reckoned before providing re- 
serves for depreciation and other charges and after they have 
been taken out there is ordinarily remaining only a small ac- 
cumulation of surplus. This is cited, not as an unusual, but 
as a typical, case of English practice. 

Sometimes the American policy is carried to an extent 
which creates a remarkable disproportion between the capital 
account and the surplus account. The Storey and Clark 
Piano Company, for example, which owns fifteen retail stores, 
is reported to have outstanding capital of $100,000 and a 
surplus of over $2,000,000. The Ford Motor Company at 
the end of the fiscal year 1914, had capital stock of $2,000,000 
and a surplus of nearly $49,000,000. However, these unusual 
relations are to be ascribed, not so much to an unusual amount 
of savings out of income, on the part of these two corporations, 
as to their omission to follow the usual practice of revising 
their capitalization from time to time to conform to tixe in- 
creasing assets and earnings. Most prosperous American 
industrials save the greater part of their earnings, but through 
stock dividends and other processes of "watering," their pros- 
perity appears in the form of enlarged capital accounts rather 
than enlarged surplus accounts. 

The Pennsylvania Railroad Company, in applying the 
principle that has been stated in the preceding section, has 
endeavored for some years to put a dollar into the surplus 
account for every dollar that has been paid in dividends. In 
other words, it aims to divide its balance of earnings, after 
providing for fixed charges, about evenly between dividends 
and surplus. During the eleven years ended June, 191 3, the 
company maintained dividends at 6% with an occasional extra 



SURPLUS 475 

dividend of i%. During these same years the additions to 
surplus as compared with capital stock were as follows: 



1903 


8.45% 


1909 


579% 


1904 


4.42% 


1910 


6.64% 


1905 


5.71% 


1911 


447% 


1906 


7.92% 


1912 


4.24% 


1907 


6.76% 


1913 


3-97% 


1908 


5-9i% 







In spite of the Pennsylvania's accumulating- surplus and highly 
conservative policy the price of the stock has been in recent 
years seeking a lower level. This is probably due in part to 
general economic conditions, but in part also to the apparent 
belief on the part of investors that the surplus of the company, 
great as it is, is no more than is required to secure the main- 
tenance of the present rate of dividends. 

Railroad companies under English influence, no matter 
where they may be located, seldom accumulate any considerable 
amount of surplus. For instance, the Buenos Ayres Great 
Southern Railway, in 1913, out of a total available surplus 
for the year of £3,157,500, after paying interest and dividends, 
carried forward only £473,600. The next year, out of £2,891,- 
200 the company carried forward only £316,100. In 191 3 the 
Buenos Ayres Great Western, out of net revenue of £1,246,500, 
carried forward £125,100. In 19 14, out of £1,041,400, they 
carried forward only £47,100. The Central Uruguay Rail- 
road, out of available surplus of £384,500, in 191 3, carried 
forward £29,900; in 1914, out of $329,900 it carried forward 
£54,100. In all these cases, the railroads were paying fair to 
good rates of dividends on their ordinary shares. 

"Rainy-Day Funds" 

Some companies make it a practice to invest a portion of 
their saved earnings, in securities or readily salable prop- 



47 6 INTERNAL FINANCIAL MANAGEMENT 

erty held outside the business, as an insurance that dividends 
will be maintained. This practice is much more common 
abroad than in this country, although not wholly unknown 
here. At the end of the fiscal year 1914, the directors of 
George Newnes, Limited, an English publishing house, pro- 
posed to carry £25,000 out of the profits of the year to a 
"Dividend Equalization Account" which would then amount 
to £50,000. It is to be presumed, though it is not so stated, 
that this "Dividend Equalization Account" would be repre- 
sented on the asset side of the balance sheet by a surplus fund 
consisting of cash or securities set aside and available for 
quick sale in case of need. Unless there are assets available 
for quick realization in cash, corresponding to such a fund, it 
is nothing more than a name. 

The great English steamship companies, which are pecu- 
liarly subject to heavy losses through the sinking of their 
vessels and similar accidents, have for many years made it a 
practice to build up surplus funds consisting of outside invest- 
ments. These funds are intended as a kind of insurance 
against marine losses that cannot otherwise be insured, and 
also for the purpose of "dividend equalization." 

One trouble with this policy is that it necessarily results in 
tying up a portion of the capital of the company in assets which 
yield only a small return. If the surplus fund is to be of any 
value for the purpose intended, it can be invested only in the 
best grade of marketable securities. Most companies which 
are prosperous and expanding do not feel that they can afford 
to take cash away from the business where it would bring 
profits of perhaps 10%, 15%, 20%, or more, in order to put 
it into securities that will yield at best 4 or 5%. Another 
objection is the fact that even this low yield does not neces- 
sarily guarantee that the company's capital put into invest- 
ments will remain intact. The officials of a manufacturing 
enterprise are not expected to be investment specialists. 



surplus A7 y 

A somewhat striking" instance is given in the record of the 
Boston Belting Company, a long-established and substantial 
New England institution, which has for many years kept up 
an 8% dividend on its stock. Some years ago the company 
received in settlement of a suit which it had brought against 
the City of Boston, a sum of approximately $1,000,000. In- 
asmuch as the cash was not needed immediately in the business, 
and as it was not thought best to distribute it to stockholders, 
it was decided to invest it in certain securities, which were 
then considered high-grade. These securities included 1,000 
shares each of the stock of the New Haven Railroad and of 
the stock of the Boston and Albany, besides other shares and 
bonds. In 1914, as a result of the drastic decline in all securi- 
ties, and especially in those which had been purchased, it was 
necessary to charge off over $400,000. Later an additional 
$100,000 was written off. It is true, of course, that the stock- 
holders, if they had received the cash, might themselves have 
made exactly the same mistake and would today be in no better 
position financially. But the feeling exists, it is understood, 
that hereafter it will be better for the company to distribute 
whatever cash is not needed and to remain strictly a manufac- 
turing, rather than become in part an investment, institution. 

In general, American thought and practice are not inclined 
to favor the diversion of capital and energy away from the 
essential and legitimate business of a company into outside 
investments. It is generally agreed that regular dividends 
combined with large — or at least adequate — savings out of 
annual income should be features of the financial management 
of most corporations. However, this belief is based upon the 
assumption that the surplus thus credited is needed for the 
development of the business and should in fact constitute the 
chief source of new capital. Wherever this assumption is 
unjustified, the general opinion would probably favor distribu- 
tion of profits even though the rate may be irregular. 



478 INTERNAL FINANCIAL MANAGEMENT 

Surplus as a Source of Capital 

In this country the accumulation of surplus out of earn- 
ings is conceived almost wholly as a source of fresh capital. 
As such it is to be contrasted with the policy of paying out 
all, or nearly all, the earnings in dividends and relying upon 
fresh issues of securities in order to obtain new capital when 
needed. 

The great advantage of securing capital through issues 
of securities is that it may be more quickly obtained and thus 
advantage may be taken of conditions which favor rapid devel- 
opment. Assume that two competitive corporations start to 
do business at about the same time with the same amount of 
capital, and that one corporation depends solely upon its ac- 
cumulating surplus for the capital with which to finance exten- 
sions, while the other corporation distributes most of its 
earnings in dividends but is successful in raising fresh capital 
by the sale of securities. If both corporations are able to 
work side by side in a normal way, it is probable that in the 
long run the first-mentioned policy will prove sounder and 
more profitable and that the stockholders in this first corpora- 
tion will eventually reap the benefits of their self-denial. But 
possibly both corporations cannot work side by side. As 
they expand, one or the other is certain to get the mastery, 
to capture the market, and to drive its competitor out of busi- 
ness. Under these conditions it may well be that the second 
corporation, through its policy of selling securities, may be 
able to raise needed capital more quickly and thus secure the 
dominating position which is the goal of both, before the first 
corporation has made a good start. 

Somewhat similar conditions frequently exist. A corpora- 
tion formed to manufacture and sell a new device may find it 
vitally necessary to cover its field before some other device 
can be brought out and introduced as an effective competitor. 
Or a company may have in hand a project which is peculiarly 



SURPLUS 



479 



timely, such as accepting a new and profitable contract. In 
all cases where the element of time in developing a business 
is a factor of great importance, the advantage, as between the 
two methods of raising capital, rests with the method of issu- 
ing securities. 

The great advantage, on the other hand, of securing capital 
through savings consists of the steadiness and soundness with 
which the business may in this way be developed. It will not 
suddenly spurt ahead — perhaps before adequate preparation 
has been made or before an effective organization can be 
brought together. It will grow, year by year, adding a new 
piece of machinery here, erecting an addition to its plant 
there, gradually increasing its organization until some day — 
almost to the surprise of its own founders — it finds itself a 
leader among its competitors. Something like this, as has 
already been intimated, was the history of the Carnegie Steel 
Company — in fact, this has been the history of probably 75% 
of the great industries of the country. The other 25%, have 
been built up chiefly by the more rapid, more attractive, and 
more dangerous process of bringing together great sums of 
capital through the issuance of securities. 

It has been remarked above that the effect of making addi- 
tions to assets through the accumulation of savings is not only 
to increase earnings, but also to stabilize them. This is due 
chiefly to the operation of the general principle that a large 
volume of business spread over a wide range of territory is 
less subject to violent fluctuations than is a smaller volume of 
business. 

Hidden Surpluses 

The remarks in one of the earlier sections of this chapter 
as to the various sources of surplus may properly be taken to 
indicate reasons for questioning the validity of the surplus 
accounts which appear on the balance sheets of many corpora- 



4 8o INTERNAL FINANCIAL MANAGEMENT 

tions. If these alleged surpluses are based on revaluation of 
the company's assets or are derived from statements of earn- 
ings that have been exaggerated over a series of years, it may 
easily happen that on searching analysis and examination they 
will vanish into thin air. There is plenty of reason for a 
questioning attitude on the part of purchasers of securities 
when they are supplied with a surplus statement. 

On the other hand, many old and well-established corpora- 
tions may properly be said to have "hidden" or secret surpluses. 
The situation arises out of the practice over a series of years 
of understating net income; of making larger provision than 
is necessary for reserves; of writing down drastically the 
book values of assets, both tangible and intangible. The result 
obviously is that the balance sheet shows an understatement 
of the value of the company's assets; and this understatement 
constitutes a hidden surplus. If the balance sheet were revised 
so as to show the true values of the company's assets, the 
surplus account would be correspondingly increased. 

In theory, the practice of understating the values of 
assets and carrying hidden surpluses is just as objectionable 
as the practice of overstating values. The real aim of the 
accountant and of the financial manager should be to see to 
it that the balance sheet tells the exact truth — neither more 
nor less — so that every creditor, every prospective purchaser 
of securities, may take action with his eyes open. However, 
this idea is not attainable and, since there must be an error 
on one side or the other, it is better to err on the side of under- 
statement and overconservatism. Bankers and careful in- 
vestors place a high value on a balance sheet that gives evi- 
dence of having been prepared with extreme caution or even 
pessimism. 

Banking houses — and sometimes other firms as well — find 
it useful to carry certain surpluses in the form of underval- 
uations of securities and other assets in order to take care of 



SURPLUS 481 

exceptional losses without disturbing the appearance of the 
balance sheet. If a bank suffers a serious defalcation, for 
example, it may be highly injurious to its credit to charge 
the whole amount directly against surplus, thus advertising 
to its customers and the world at large that it has met with 
a set-back. In case the bank has been carrying assets at an 
undervaluation, it may resort in such a case to a revaluation 
of these assets so as to increase them by approximately the 
same amount as the loss that is to be written off. When 
the next balance sheet appears it shows no difference except 
that the skilled analyst might be able to detect changes in 
the valuations of assets; but this is not usually possible. 

Hidden surpluses have been known to exist, not because 
of an especial degree of conservatism on the part of directors, 
but because it is deliberately intended to deceive sharehold- 
ers as to the real value of their property. The shareholder 
is induced to sell, when his shares are desired by those on 
the inside, at a bargain price. Usually the next steps are 
to show the full amount of the earnings and surplus — with 
perhaps some inflation — to recapitalize and to sell the new 
issues at a heavy profit. 

This is a subject which will again be referred to in the 
chapters which discuss methods of exploitation. 



CHAPTER XXI 
BUDGETS 

Nature and Types of Budgets 

In handling governmental business in nearly all civilized 
countries, it is customary for the executive power to submit 
to the legislative power a detailed estimate of the prospective 
revenue and outgo for the succeeding fiscal year. This esti- 
mate is known as a budget. It may be described as a detailed 
income and expenditure statement made out in advance of the 
period which it covers; it is a prediction or a guide, not a 
record of results. In governmental practice it is customary 
to secure the approval of the legislative power after required 
revisions have been made ; and thereupon the adopted budget 
in its final form becomes a binding appropriation of the 
expected revenue. The various departments of the govern- 
ment are not authorized to go beyond the sums appropriated 
to their departments in their expenditures for the fiscal year. 

In private corporations the budget, except in rough and 
fragmentary form, has not been much used. There is a grow- 
ing interest, however, in the application of the principle of 
the budget in some practical form with a view to forestall- 
ing the serious financial errors and miscalculations that so fre- 
quently wreck the careers of otherwise successful corpora- 
tions. Many directors and treasurers of corporations con- 
sider the present practice entirely too loose and too near- 
sighted and are looking to the budget as a means of better- 
ing these conditions. It should be possible to make detailed 
financial plans and schedules for a year or more ahead, just 
as it is possible for many companies to make detailed operat- 
ing plans and schedules. 

482 



BUDGETS 



483 



Budgets are divisible into two classes — those which are 
merely estimates for the benefit of the active financial mana- 
gers and those which are adopted as binding appropriations. 
It is usually best to start by making budgets of the first 
class — unless there is some emergency which demands that 
a definite financial plan be adopted and adhered to — always 
having in mind the expectation that the budget will in time 
reach the stage of being either formally adopted or accepted 
by general agreement as stating the limit for the year's expen- 
ditures. 

Objections to the Use of Budgets 

A constantly recurring objection, not only to formal bud- 
gets, but to all attempts to make advance estimates, is that the 
volume of sales of most corporations is not under control, 
nor can it be foreseen. There is undoubtedly much truth in 
this assertion. Yet in the great majority of cases this difficulty 
is exaggerated. As a matter of fact, the manufacturer or 
trader should be able, within reasonable limits, to exercise a 
fairly close control over the volume of his sales; if not, his 
business is clearly on an extremely unsound basis. His past 
experience should give him a reasonably clear idea of the 
normal percentage of costs to volume of business in his line. 
And, while the mere process of increasing selling expenditures 
will not in itself increase the volume of business, the pro- 
prietor should be able, with reasonable regard to conditions, 
to estimate with fair certainty the selling expenditures that 
will increase his business to a predetermined volume. 

It is also true that in many lines of business extreme fluc- 
tuations take place from time to time. Manufacturers of rail- 
way supplies, for example, are able to sell more of their product 
when the railroads are prosperous, but no extra selling effort 
will maintain their sales when the railroads are not making 
money and cease to buy. 



484 INTERNAL FINANCIAL MANAGEMENT 

It is the business of the budget-maker to form a careful 
estimate of the probable results of increased selling expendi- 
tures, giving due weight to all factors both favorable and 
unfavorable. His ability as a financial man will be tested by 
the degree of accuracy with which he can foretell the probable 
business conditions of the coming year. 

In estimating the coming volume of business, three fac- 
tors should be considered : ( 1 ) estimated expenditures during 
the coming year directed toward building up sales ; (2) normal 
proportion of sales expense to volume of sales; and (3) prob- 
able effect of general business and financial conditions on the 
particular line of business. 

The uncertainty as to the result of the selling effort is the 
crucial difficulty to be overcome. Once the anticipated volume 
of business is calculated, it is comparatively simple to deter- 
mine the expenditures necessary for the proper handling of 
this estimated volume. 

Another related objection to budget-making is to the 
effect that the business will fluctuate widely with business 
conditions and will not run in a uniform channel. This objec- 
tion simply tends to show, first, that the budget should be 
made on a monthly rather than on a yearly basis with a view 
to increasing its accuracy and, in the second place, that a 
margin should be allowed for inaccuracies and fluctuations. 

A third objection to all budgets is the alleged danger of 
introducing red tape and hampering the free judgment and 
action of operating officials, which is essential to an energetic 
and growing enterprise. The obvious answer to this objection 
is that the free and untrammelled action of sales managers, 
buyers, superintendents of factories, and other operating of- 
ficials, has been probably the most prevalent cause of financial 
embarrassments. 

As a matter of fact, a definite and binding budget, which 
can be debated and settled by all the responsible officials and 



BUDGETS 



485 



the directors of a company at the beginning of a fiscal year, 
is a highly effective method of securing the unitedness of 
purpose which is an essential factor in every efficient organi- 
zation. 

Necessity for Continual Revision 

The objections above cited are all based on the assumption 
that a budget once adopted is an absolutely inflexible and un- 
changeable strait- jacket from which no relief can be obtained 
until after the expiration of the fiscal year in which it holds 
good. If this were actually the state of affairs, the objections 
would have weight. But the efficient budget, as used by some 
corporations, is subject to continual revision. 

First of all, it is made both on a yearly basis and on a 
monthly basis. The yearly budget enters into few details, 
but gives a comprehensive view of the anticipated income from 
various sources — the anticipated expenditures, together with 
the approximate result of the whole year's business. 

Supplementing the yearly budget and controlled by it, are 
the monthly budgets, which enter into as much detail as may 
be required by the nature of the business, and make due allow- 
ances, so far as they can be foreseen, for the seasonal and 
month-by-month fluctuations which occur in every business. 
The month-by-month budget may be checked up at the end 
of each month against the actual results of that month; the 
causes of discrepancies may be noted; new contracts or pros- 
pects for enlarging or reducing business during the months 
immediately following, may be taken into consideration. With 
all these and other similar factors in full view, such revisions 
as are at the time required may readily be agreed upon. 

Income Basis vs. Cash Basis 

A practical question that must be answered before the 
budget can be prepared is whether it should be based upon 



4 86 



INTERNAL FINANCIAL MANAGEMENT 



income and expenditures or upon cash receipts and cash dis- 
bursements. Income and expenditure constitute the correct 
measure of profits and therefore should be used whenever the 
prime purpose of the budget is to control expenditure and to 
insure a satisfactory showing of profits during the ensuing 
year. Cash receipts and cash disbursements, on the other 
hand, measure the financial status and financial prospects of 
the business and should be used whenever the prime purpose 
is to make sure that the business will run on a basis that is 
financially sound. 

The truth is that all successful plans for business should 
contemplate both prospective income and expenditure and 
prospective receipts and disbursements, and that emphasis as 
to which of the two is more important depends to a consider- 
able extent upon the business. In all cases except those in 
which income and expenditure and receipts and disburse- 
ments are practically identical, there should be two separate 
budgets. The income and expenditure budget should be for 
the guidance of all the operating officials of the company; it 
should show in some detail the amounts that may be expended 
and the results that are expected in each department. This is 
the budget that serves the purpose of facilitating control. 

The receipts and disbursements budget may be only for 
the private information and guidance of the treasurer, or of 
those who are responsible for the financial management of the 
company. It will indicate just where the actual cash receipts 
of each month are to come from and through what channels 
the cash is to flow out. 

The budget of cash receipts and expenditures may itself 
be divided into two parts, the first part including only those 
transactions which have to do with current operations, and 
the second part including only capital transactions. By com- 
bining the two parts the financial management may look ahead 
and make certain that ample bank balances will be maintained ; 



BUDGETS 487 

calculate to what extent they will be dependent upon bank 
and other loans ; determine exactly how far they should go in 
taking advantage of cash discounts; and otherwise guide the 
financial course of the company with skill and accuracy. 

Income Budgets 

Taking up now in more detail the procedure in forming 
a budget, first on the income and expenditure basis, and 
second on the receipts and disbursements basis, we have to 
consider the extent of the income for the period (whether it 
be monthly, half-yearly, or yearly) which may fairly be re- 
garded as assured. Manufacturing companies are likely to 
have certain regular customers on whom they may safely 
count, unless extraordinary conditions prevail, for a given 
amount of business. The same thing is true of wholesale 
trading companies. The companies, both manufacturing and 
trading, which are selling at retail, can at least work out from 
their own records the minimum limits of their sales. The 
same thing may be done by public service and transportation 
companies. Companies which operate on long-term contracts 
extending over two or three years or more may conceivably be 
in the position of having all their capacity occupied with con- 
tracts previously arranged, in which case all their income will 
be assured. 

Most companies have in addition certain possibilities which 
require careful study and good judgment in order to make 
possible a reasonably accurate estimate of earnings which are 
not assured but are probable. In making up these estimates, 
the financial manager will naturally be guided to a great extent 
by the views of the sales manager and other operating officials 
who are probably in closer touch than he is with the company's 
sources of income. It is well to state separately the amount 
of gross earnings which may be regarded as probable but is 
not assured. 



4 88 INTERNAL FINANCIAL MANAGEMENT 

The classification of expenses should follow the same lines 
of division. It is well to estimate, first of all, what may be 
called the fixed and necessary expenses of the business, assum- 
ing usually that it is intended to hold intact the organization 
that has been built up. These necessary expenses will include, 
therefore, the salaries of officers and their assistants, of sales- 
men, clerks, and working men, the purchases of raw mate- 
rials necessary for production up to the amount that is assured, 
the up-keep of the plant, and other necessary expenses. 

A second section will show the increase in expenses neces- 
sary in case the probable volume of business, as previously 
estimated, is secured. A third section will show further in- 
creases necessary in case the possible volume of business is 
attained. 

Cash Budgets 

The receipts and disbursements budget may be arranged 
in three divisions to correspond; or it may be necessary to 
base it wholly upon the estimate of possible earnings. In 
those lines of business, however, in which sales are made on 
a long-term or instalment basis, it will be found of the highest 
importance to make the receipts and disbursements budget in 
considerable detail and with a view to all possible contingen- 
cies. Not to do so is to invite serious trouble, for an enlarged 
volume of business in such industries necessarily means a 
proportionate or more than proportionate tying up of cash 
resources. A budget may even indicate that for this reason 
it is unwise to attempt to handle the volume of business which 
the sales manager and operating officials would like to secure. 
The making of a receipts and disbursements budget may be 
sufficient in itself to reveal the breakers ahead and to inspire 
caution. 



CHAPTER XXII 

FINANCIAL STANDARDS 

Need for Standards 

A man who keeps all his property in the form of cash and 
government bonds has comparatively little to worry or think 
about; but, on the other hand, he is not using his resources 
productively. As the same man proceeds with the development 
of some business enterprise, he puts more and more of his 
capital into the various forms of tangible and intangible assets 
which are required for the upbuilding of the business. 
Presently, if he is not careful, he may find himself short of 
cash and unable to meet his obligations, although he may be 
earning good profits. 

The same tendency is present everywhere. The executives 
who are managing the financial affairs of a company cannot 
assist in making the business profitable merely by piling up 
unnecessary cash resources. They must be prepared to venture 
out into the main current of business affairs along with their 
associates. And as they venture farther and farther, the danger 
increases that their financial craft may be swept out of their 
control. It requires constant watchfulness and sound knowl- 
edge to steer a middle course between excessive caution on the 
one side, and rashness in financial management on the other. 

It would be far easier to keep to this middle course if the 
safe channels were more clearly marked out. A manufac- 
turer, for example, takes on an enlarged volume of business 
with the result that his working capital is much reduced; he 
finds it difficult to determine with any accuracy whether this 
reduction is approaching the danger point or not; he has no 
definite rule or standard by which to guide his course. 

489 



490 



INTERNAL FINANCIAL MANAGEMENT 



Many such standards of operating and financial practice 
are established for particular industries by general consent. 
These standards are in many cases probably incorrect, but they 
serve to assist those who are forming and testing policies. 
For example, the percentage of cost of carrying on various 
lines of retail business, in comparison with the gross sales of 
the business, has been studied. It is generally said that the cost 
of conducting a retail book store is about 28% of the gross 
sales. Again, in many lines of manufacturing the percen- 
tages of prime cost, of overhead, and of selling cost, to the 
prices of the articles manufactured, are quite definitely agreed 
upon. 

As yet no general standards of financial practice have 
been worked out in any detail or with any approach to ac- 
curacy. At this stage, it is not possible for any individual to 
collect and collate all the data that would be necessary to make 
a complete line of standards of financial practice. This work 
should be done by such associations as the American Institute 
of Accountants, the American Bankers' Association, the In- 
vestment Bankers' Association, and the United States Chamber 
of Commerce. If such a work were done the result would be 
of the highest value to business managers. 

Relation of Working Capital to Total Capital 

Following are the percentages of working capital to total 
capital as shown in recently published balance sheets of a con- 
siderable number of prominent American industrial corpora- 
tions, which have been selected practically at random. For 
convenience, these companies are divided, for the present 
purpose, into three groups: those having a proportion of 
working capital below 15% of total capital being placed in 
the first group; those having between 15 and 35% in the 
second group and those having above 35% in the third 
group. 



FINANCIAL STANDARDS 49 ! 

Percentage of Working Capital to Total Capital 

I 

Mexican Petroleum Company 3-5% 

California Petroleum Company 3-9% 

Pittsburg Coal Company , 8.9% 

United Fruit Company 9 % 

Railway Steel Spring Company 13 % 

II 

Sears-Roebuck Company I 5- I % 

United States Steel Corporation 16.2% 

Pressed Steel Car Company 18.3% 

General Chemical Company 19 % 

New York Air Brake Company 21 % 

National Lead Company 24 % 

Lackawanna Steel Company 24.4% 

Baldwin Locomotive Company 28.1% 

Cambria Steel Company 33-5% 

III 

Crex Carpet Company 36.8% 

Armour and Company 37 % 

American Woolen Company 37-4% 

American Sugar Refining Company 39-6% 

American Tobacco Company 42.8% 

Underwood Typewriter Company 43-2% 

Central Leather Company 48.6% 

Swift and Company 51 % 

Rumely Company 52.6% 

Morris and Company 53 % 

Deere and Company 70 % 

International Harvester Company 81.3% 

It is interesting to observe that, with one or two striking- 
exceptions, companies which are competitive or which do the 
same general class of business have approximately the same 
relations of working to total capital. Note, for example, the 
close correspondence between the California Petroleum Com- 



492 



INTERNAL FINANCIAL MANAGEMENT 



pany and the Mexican Petroleum Company. The only other 
company in the list which is engaged in the extraction of raw 
materials is the Pittsburg Coal Company, which also has a 
low percentage. Extractive companies have little need for 
large inventories, stocks of raw material, or other working as- 
sets, except cash and accounts receivable. And their accounts 
receivable do not run for long periods. The United Fruit 
Company is, to a large extent, engaged in transportation 
rather than in producing and selling. As has been previously 
pointed out, transportation operations do not call for large 
amounts of working capital. 

The various railway equipment companies, including the 
Railway Steel Spring Company in Group I and the Baldwin 
Locomotive Company, the New York Air Brake Company, 
and the Pressed Steel Car Company appearing in Group II, 
all have a low proportion of working capital compared with 
other industrial companies. It may be assumed that in railway 
equipment manufacturing, comparatively little money is tied 
up in accounts receivable. The railroad companies pay usually 
in the form of notes which are readily discountable, thus 
making unnecessary, for reasons that have previously been 
discussed, a large excess of current assets over current lia- 
bilities. 

All the steel manufacturing companies, including the 
Cambria Steel Company, the Lackawanna Steel Company, and 
the United States Steel, are included in the second division, 
and all except the Cambria Steel Company have working 
capital proportions below the average. 

In Group III are included a number of important companies 
which may. be subdivided into two classes : those which find it 
necessary to carry large inventories or materials, goods in 
process, and finished goods, and those which find it necessary 
to sell on an instalment or long-term basis, so that accounts 
receivable are always heavy. The first-mentioned class in- 



FINANCIAL STANDARDS 493 

eludes American Sugar Refining Company, American Tobacco 
Company, American Woolen Company, Central Leather Com- 
pany, and Crex Carpet Company. 

The three agricultural implement companies in this group, 
International Harvester Company, Rumely Company, and 
Deere and Company, as well as the Underwood Typewriter 
Company, belong in the class which sell their products on long 
terms. 

The meat-packing companies — Morris, Swift, and Armour 
— find it necessary to carry large inventories of live stock 
and of goods in process. 

On the whole, in running over the list that has just been 
given and in examining large numbers of other industrial 
balance sheets, it becomes fairly evident that well-managed 
business enterprises customarily follow standards that are 
more or less similar and that lead them to establish similar 
proportions of working to total capital. The exceptional cases, 
both above and below the normal proportions, are for the most 
part readily explainable. 

Cash and Cash Resources 

Closely related standards and tests apply to the propor- 
tions of cash and resources immediately convertible into cash 
(principally securities held for sale) to total capital, to gross 
volume of business, and to current liabilities. 

Inasmuch as banks are devoted almost exclusively to 
handling cash and credit, we should naturally expect that 
their practice in respect to these factors would be more defi- 
nitely standardized than the practice of mercantile manufac- 
turing companies, and this is actually the case. The experience 
of financiers over many generations has gradually crystallized 
into the conclusion that in an ordinary commercial bank, which 
is effectively using most of its capital in its own business, that 
capital ought to be invested chiefly or wholly in cash or at 



494 



INTERNAL FINANCIAL MANAGEMENT 



least in cash and secondary reserves immediately convertible 
into cash. The proportion of cash to demand liabilities has 
been fixed by long experience at from 15 to 25%. 

The practice of industrial concerns in handling cash is, 
of course, on an entirely different basis and is not so readily 
standardized. The proportion of cash to total capital varies 
from as low as 1% to as high as 16%, which has been at- 
tained by the General Electric Company. It very seldom, 
however, runs higher than 7 or 8%, which is considerably 
above the average. 

The remarkable discrepancy between the practice in this 
respect in the United States and Canada should be noted. In 
the last-named country the relations between banks and indus- 
trial enterprises are much closer than is customary in the 
United States. The Canadian companies depend much more 
largely upon bank borrowings to restore their cash balances 
whenever they become depleted. Nor do the banks impose 
the requirement, which is customary in this country, that 
bank balances should average at least 20 to 25% of bank 
loans. 

The Canadian practice as outlined above is in accord with 
the practice in most European countries, particularly in Ger- 
many, and with the practice of European corporations operat- 
ing in South America and other foreign countries. Canadian 
practice emphasizes the suggestion that the proportions of cash 
and cash resources to capital, sales, and liabilities, depend 
largely upon the nature of the company's banking connections. 
Or, to repeat the phrase used in a preceding chapter, the re- 
quired amount of cash depends upon the "convertibility into 
cash of other working assets." 

In most American industrial companies, the proportion of 
average cash to gross sales is about 3 to 6%. If the company 
is paying its bills promptly and is not overborrowing, current 
liabilities should not exceed 20 to 30% of annual sales. This 



FINANCIAL STANDARDS 



495 



refers, of course, to the business of manufacturing a standard 
article or articles which can be sold in fairly steady volume. 
On the basis of these figures, cash and cash resources should 
be about 12 to 25% of current liabilities, and this is not far 
from the customary showing. 

Turnover 

The definition of the term and the reasons for laying 
great importance upon quick turnover have previously been 
discussed. The additional point that belongs in this chapter is 
a statement as to the ratio of turnover which may be accepted 
as standard in various lines of business. This statement is by 
no means complete or conclusive, but is based upon the frag- 
mentary information which it is now possible to obtain from 
the records of business firms. 

A cotton goods commission house which does a little financ- 
ing of sales, employs some traveling salesmen, and carries no 
stock, has total working assets of $400,000. The annual 
sales of this house are about $3,500,000, showing a turnover 
of nearly 900%. This is regarded as a good, though not ab- 
normal, showing. 

A large department store is said to carry an average stock 
of $8,000,000 to $10,000,000, and to have average sales of 
$15,000,000 to $20,000,000, showing a turnover of 200%. 

It is said, on excellent authority, that many retail grocers 
make a complete turnover at least once a month, equivalent 
to 1,200% for the year, while country stores, which are forced 
to carry a large assortment of stock, are well satisfied to do 
300 to 400%. One small retail store is recently reported to 
have done 900%, but this is an extraordinary showing. 

Operating Ratios 

One of the most important standards or tests of efficiency 
in all lines of business is the percentage of total expense of 



496 



INTERNAL FINANCIAL MANAGEMENT 



running the business, including manufacturing, selling, and 
administration, to the gross sales — more commonly known 
as the "operating ratio." It is clear that the difference between 
1 00% which represents gross sales and the operating ratio is 
the percentage of gross profit on sales. The lower this per- 
centage of gross profit — or, in other words, the higher the 
operating ratio — the more unstable, other things being equal, 
is the business as a money maker ; for a high operating ratio 
means that even a slight variation in expenses may be suffix 
cient to transform a profit into a loss. On the other hand, 
a phenomenally low operating ratio indicates a business which 
is earning excessive profits and is therefore peculiarly subject 
to competitive attack. 

The term was first applied, and is still most generally used, 
in connection with steam railroads. The ratio here is low, 
usually not more than 70% ; sometimes it climbs to 80% and 
90%, and sometimes falls as low as 55%. This low ratio 
is offset by high fixed charges. In 1906 the ratio of the 
Chicago, Rock Island and Pacific Railway went up to 89%, 
and in 1907 to 87%. The ratio for electric railways decreased 
from an average of 60.1% in 1907, to 58.7% in 1912. The 
lowest figure was 57.5% in 1902. However, the operating 
expenses for 19 12 included over $7,000,000 charged for de- 
preciation, compared with no similar charge for the earlier 
years. Some recent ratios of industrial companies are the 
following : 

Westinghouse Air Brake Company 61% 

American Piano Company 64% 

Sears-Roebuck Company 89% 

American Steel Foundry Company 90% 

F. W. Woolworth Company 91% 

Wells-Fargo Express Company 93% 

American Express Company 94% 

Kresge Company 94% 

Adams Express Company 97% 



FINANCIAL STANDARDS 497 

Companies which manufacture specialties that enjoy a 
ready market and are protected by patents or otherwise from 
effective competition, may properly have a light operating 
ratio and an unusually large percentage of profit on sales. 
This is presumably the case with the Westinghouse Air Brake 
Company and perhaps with the American Piano Company. 
Normally, a manufacturing concern w T ill have a ratio not far 
from 90%, as shown in the above list by the American Steel 
Foundry Company. Trading companies, such as Sears-Roe- 
buck, the Kresge Company, and the F. W. Woolworth Com- 
pany, run as high or even a little higher. The three express 
companies, and particularly the Adams Express, are running 
on a dangerously close margin, due to the persistent rise in 
expenses and reduction in revenue during recent years. For- 
merly a ratio of 87 to 93% was about normal. 

Stock and Bond Issues in Relation to Gross Earnings 

Assuming that the operating ratio of a company is not far 
from normal in its line, a fairly definite relation may be some- 
times established between gross earnings and stock and bond 
issues. In the chapter on capitalization (Chapter VIII) it 
has been suggested that industrial companies frequently show 
a total capitalization approximately equal to their gross earn- 
ings. This relation may easily exist wherever the percentage 
of profit on sales is about equivalent to the percentage of profit 
expected on capital invested in that industry. Inasmuch as 
companies which carry on a business that involves considerable 
fluctuations and risks expect a high percentage of profit both 
on sales and on capital invested, it is clear that the correspon- 
dence between gross earnings and capitalization is not purely 
accidental. 

Wherever the operating ratio, however, leaves a margin 
of profit on sales that is either much higher or much lower 
than the expected rate on invested capital, this relation of 



498 



INTERNAL FINANCIAL MANAGEMENT 



equality between gross earnings and capitalization will not 
exist, but will be supplanted by some other fairly stable ratio. 
Companies which do a large business on a small margin — 
commission houses, retail stores, manufacturers of staples, 
and the like — will customarily have a capitalization much 
smaller than gross sales. Companies like railroads, interurban 
lines, and public utilities, which have a low operating ratio, 
will customarily have a capitalization of several times their 
gross earnings. Electric street railway companies normally 
have a capitalization of four to six times gross earnings. 
A little figuring based on the normal operating ratio and 
the normal relations of gross earnings to capitalization in any 
given line of industry, will often prove an exceedingly helpful 
method of testing in a rough way the capitalization that will 
be proper for a given enterprise. 

Analysis Based on Financial Standards 

Bankers, credit men, investors, and others who are not 
intimately acquainted with a given business, are frequently 
called upon to form tentative judgments as to the financial 
efficiency of a business, based chiefly upon statements of ac- 
count that are furnished to them, or even upon a few uncon- 
nected figures. The process of piecing together these 
fragments and from them forming a fairly definite mental 
picture of the status and efficiency of the concern, is not unlike 
the work of those scientists who from a few small bones are 
able to reconstruct the skeleton of some prehistoric animal. In 
making an analysis and "reconstruction" of this kind it is 
helpful to be guided by whatever financial standards are avail- 
able which apply to the business under consideration. 



Part V — Financial Abuses and Involvements 



CHAPTER XXIII 

EXPLOITATION BY OFFICERS 

Exploitation Differs from Fraud 

Exploitation differs from simple fraud in that it is more 
subtle, more difficult to trace and expose, and ordinarily gives 
no grounds for legal action to obtain redress. In its study 
there is no one act or set of acts to be listed and definitely 
described; it takes an infinite number of forms and in many 
cases is never known or recognized even by its victims. 

Nor is there any clear certainty, ordinarily, that a company 
has been deliberately exploited, even though it may have been 
wrecked and the facts as to its management may have become 
known. It may often be proved, of course, that those in charge 
of the company's affairs have secured personal profits and that 
the results of the transactions out of which they have made 
profits have been injurious to the company which they served. 
Yet the plea may always be made that mistakes of business 
judgment are common to all enterprises and that it is easy 
to sit back and criticize after the results of a given line of 
action have become known. 

The Corporate Form Favors Exploitation 

The general adoption of the corporate form of organizing 
business enterprises has opened up new and previously un- 
thought-of fields and methods of exploitation. The corporate 
form is singularly well adapted for exploiting activities. 
Through the creation of a small corporation, an individual 

499 



c;oo FINANCIAL ABUSES AND INVOLVEMENTS 

may wholly or partially hide his own identity and rid himself 
of personal responsibility. The large corporation with its 
thousands or tens of thousands of shareholders, few of whom 
know much about or take a personal interest in the fortunes of 
their corporation, offers an inviting opportunity for exploita- 
tion. It requires a man of really strong character and of 
unusual conscientiousness to avoid the temptation of using an 
important office in a corporation of this character for the prime 
purpose of building up his personal bank account. To the 
credit of corporate officers and directors it must be said that the 
great majority devote their undivided efforts to the service 
of their corporation and the stockholders whose interests they 
represent. 

The legal fiction of "corporate entity" which has been more 
rigorously upheld and applied in American courts than in 
English courts, has undoubtedly been a highly important factor 
in favoring exploitation. Any individual who so desires may 
readily organize and control a corporation in which he may 
not personally appear either as a director or an officer ; indeed, 
he may not even be on the books as a stockholder of record. 
With this corporate mask over his face, the exploiter may go 
ahead boldly looking for victims, and may even, under this 
new guise, operate successfully on the pocketbooks of those 
whom he has previously robbed. 

Petty Abuses by Subordinate Officers 

In a corporation which is conducted by able business men 
who are single-mindedly devoted to the upbuilding of the 
corporation, it is probable that nearly all subordinate officers 
will be of the same type. In the business world, as everywhere 
else, like attracts like. Men who are themselves honorable 
prefer to work under chiefs of the same type. If they suspect 
that their company is being exploited by its officers, they 
naturally seek an opportunity to leave and their places are 



EXPLOITATION BY OFFICERS r OI 

taken by men who are perhaps less able or less scrupulous. 
There are, of course, innumerable exceptions on both sides, 
but the general rule holds good. Consequently, when we find 
a company in which the chief officers have been primarily en- 
gaged in exploitation, it is only too likely that petty graft will 
not be unknown among the subordinates. 

Under the old regime of the New Haven Railroad Com- 
pany, according to the report of the Interstate Commerce 
Commission, the company purchased its rolling stock almost 
exclusively and without competition from one man. This man 
sold the company approximately $37,000,000 of equipment. 
He made no secret of his generosity in making valuable 
presents to the officials with whom he did business, but claimed 
that these officials were old friends of his. 

The purchasing officers of large corporations are naturally 
subject to special temptations, inasmuch as they frequently 
control contracts of great importance. It is, however, a very 
rare occurrence to find even a tinge of suspicion resting on 
these men, almost all of whom command the complete con- 
fidence of their associates and of those with whom they do 
business. 

Exorbitant Salaries 

In a small corporation which has come into the control 
of one faction and is being exploited to the detriment of the 
general body of stockholders, the simplest and most common 
method is through payment of exorbitant salaries. So long 
as the salaries are kept within the bounds of reason and so 
long as the real purpose — which is to distribute profits in 
this form — is not made too plainly evident, this practice is 
legally unassailable. It may, however, become dangerous to 
the exploiters in case their salaries are suddenly jumped, or 
in case there is a rearrangement of salaries which so clearly 
corresponds to shareholdings as to leave no doubt that the 



502 



FINANCIAL ABUSES AND INVOLVEMENTS 



increases are really mere devices for distributing dividends to 
the dominant faction at the expense of the other shareholders. 

Contracts That Benefit Officers 

The history of the Standard Rope and Twine Company, 
which was formed in 1895 to take over the assets of the in- 
solvent United States Cordage Company, illustrates some of 
the possible methods of exploiting a corporation to the per- 
sonal advantage of the officers. The first president was 
accused — whether justly or unjustly cannot be definitely de- 
termined — of discriminating against the Standard Com- 
pany in favor of a competing concern in which he was a part- 
ner, turning the less profitable contracts toward the former 
and the more profitable ones toward the latter. In 1896 the 
president proposed that the Standard Company should take 
over certain processes controlled by him for forcing oil into 
rope. The company made a contract which gave the presi- 
dent authority to spend $25,000 of the company's money in 
perfecting his invention, and, as a matter of fact, much more 
than this originally authorized amount was spent. In the 
end the process proved worthless and the company had to 
bear a heavy loss amounting to over $126,000.* 

One of the worst scandals in American financial history 
was that connected with the famous Credit Mobilier. In 1864, 
while the Union Pacific Railroad was under construction, one 
of the vice-presidents through a "dummy" secured a contract 
for the construction of a large section of the line. This con- 
tract was assigned to the Pennsylvania Fiscal Agency, the 
name of which was later changed to "Credit Mobilier. ,, Stock- 
holders of the Union Pacific were allowed to obtain Credit 
Mobilier stock and thus become stockholders in both concerns. 
As a result of this arrangement, all incentives to economy 
of construction were removed. Credit Mobilier obtained all 



*Dewing's "Corporate Promotions and Reorganizations," pp. 158, 159. 



EXPLOITATION BY OFFICERS 



503 



the contracts it cared for on very attractive terms, and made 
profits variously estimated at from $17,000,000 to $23,000,000, 
in which the officers of the railroad had a large share.* 

Divergence of Business to Other Companies 

A more ingenious and more insidious form of exploitation 
for the advantage of officers consists in diverting profitable 
business from the corporation which the officers are serving to 
another corporation in which their personal interests are larger. 

The question as to when an officer is entitled to use for 
his personal benefit knowledge that comes to him in the per- 
formance of his duties and when he is under obligation to use 
it exclusively for the benefit of the corporation, is often puz- 
zling. For example, the manager of a manufacturing concern 
has had brought to his attention a new device which is likely 
to prove highly profitable. The information comes to him as 
an individual, not as an officer. Is he entitled to organize a 
new company and to become personally interested in the 
manufacture of the device ? Or is he under obligation to turn 
over the information he has secured to his company? As a 
practical matter, probably few would object if the officer, under 
such circumstances, were to drop his former connection and 
devote himself to the new enterprise. 

This leads, however, to the next question : whether it 
would be proper for the officer to become interested as a stock- 
holder and director in the new enterprise without dropping 
his connection as an officer. If it is granted that he may 
properly do so, can any objection be raised to his permitting 
the company which manufactures the new device to do busi- 
ness with the company of which he is an officer? And, if we 
grant that the officer may proceed to that extent, can objection 
be raised to his actively favoring the use of the new device 
by the company of which he is an officer? 



*Daggett's "Railroad Reorganization," pp. 223, 224. 



504 



FINANCIAL ABUSES AND INVOLVEMENTS 



It will be seen that the honest and honorable course in 
such matters is not always clear, and men whose ideals of 
business honor are hazy often fail to keep on the right side of 
the line. A director of a corporation should regard himself 
and act as a trustee for the stockholders he represents, and 
their interests should come before his own. 

"Unloading" and Securing Control 

A somewhat different case arises when the officers of a 
corporation are financially interested in another company 
which has proved to be a money loser or which needs assis- 
tance. If the business in which they are interested is in any 
way related to the business of the corporation of which they 
are officers, it is frequently an easy and tempting procedure 
to "unload" a portion of their holdings or to secure financial 
assistance in some other form. The process is especially easy 
when the active officers are able to work together without 
interference in putting through their plans, and when their 
fellow directors have little direct personal knowledge of the 
details of the business. 

Sometimes schemes of the same general type may be put 
through with a view to enabling the officers to secure personal 
control, for their own benefit, of another company in which 
they are financially interested. By inducing the company in 
which they are officers to take stock additional to their own, 
they may be able to acquire the desired control. 

It is not necessary to say that schemes such as these involve 
a clear breach of a director's duty and are in themselves incom- 
patible with the higher standards of business conduct. Each 
case must be judged on its own merits. 

Misuse of Inside Information 

Another common method of exploitation is through the 
misuse by officers or directors of information which comes to 



EXPLOITATION BY OFFICERS 



505 



them on the "inside" but which is unknown to other stock- 
holders and perhaps unknown to all other officers and direc- 
tors of the corporation. This is most likely to occur in con- 
nection with speculation, either in the company's own shares 
or in products the price of which can be affected by the cor- 
poration's activities. 

As to the misuse of inside information for the purpose of 
speculating in the shares of their own company, innumerable 
instances might be given. The results are quite likely to be 
unfortunate for the officers, themselves, due partly to the fact 
that the information upon which they act is, in many cases, 
fragmentary, and due also to the fact, which many people 
fail to realize, that the up and down movements of stock 
market prices are determined only in part by the intrinsic 
merits of the securities. Fluctuations arise more largely from 
general economic and market influences, with which the offi- 
cers of most industrial corporations are not especially familiar. 

Is Exploitation a Common Evil? 

As has been intimated at the beginning of this chapter, 
exploitation as a factor in business transactions is perhaps a 
more common evil than it was in the days when business or- 
ganizations were simpler and under the more direct control of 
their owners. The officer or director of the modern corpora- 
tion occupies a position, not merely of dignity and responsi- 
bility, but also of trust. This trusteeship is more clearly 
recognized, perhaps, than was the case a generation or more 
ago. But the ascendency of the higher standards, which are 
implied in a sense of trusteeship, comes slowly and is the 
result of innumerable hard struggles. In the meantime, ex- 
ploitation in its myriad forms goes on apparently unchecked, 
while, on the surface, financial transactions usually appear reg- 
ular, and plausible reasons can easily be advanced for ap- 
proving them ; yet, once in a while a lawsuit or an investigation 



5 o6 FINANCIAL ABUSES AND INVOLVEMENTS 

suddenly tears away the silken covering and reveals the ugly 
figures of greed and graft. Our surprise and dismay for the 
moment are acute; then we forget. We regain a feeling of 
security which remains until the next unpleasant incident 
occurs. 

It seems probable, however, on the whole that the sense 
of business honor is more developed today than ever before. 
It is certain that the laws against corporate malfeasance are 
more stringent than before and undoubtedly these laws reflect 
a real development of business conscience. 



CHAPTER XXIV 

EXPLOITATION BY DIRECTORS AND MAJORITY 
SHAREHOLDERS 

Enlarging the Circle of "Insiders" 

The preceding chapter disclosed some of the methods by 
which the active officers of a corporation may use their posi- 
tions to carry through transactions which are primarily in 
their own interests and are injurious to the interests of all 
the other shareholders, including even their fellow officers 
and directors of the corporation. Now we have to consider 
instances in which the circle of inside schemers is enlarged 
so as to include all, or a majority, of the members of the board 
of directors, who misuse their positions to the injury of their 
fellow shareholders. The circle may be enlarged to include 
a majority of the shareholders who exploit the minority share- 
holders ; or it may even be further enlarged to include all the 
shareholders who are banded together for the purpose of 
exploiting the creditors. 

The principal methods employed do not differ funda- 
mentally from those previously described, and may take the 
form of unfair contracts with a corporation, or of sales at 
exorbitant prices, or of misstatements of fact, thus misleading 
some of the outsiders into buying or selling at far above or 
below fair valuations, or of misusing the resources of the 
corporation to assist in outside ventures or speculations. These 
are the basic methods which in their infinitely varied forms 
are used again and again. 

Juggling Accounts 

Corporate accounts and statements are juggled for various 
reasons. One of the most common of these is to make a good 

507 



5 o8 FINANCIAL ABUSES AND INVOLVEMENTS 

showing for the administration in power. Sometimes mis- 
leading statements are put out to enable officers and directors 
to buy or sell shares of their own company to advantage. 
Sometimes promotion promises require dividends when divi- 
dends should not be declared and the accounts are so juggled 
as apparently to authorize these unjustified dividends. 

While the technical intricacies of juggling corporate ac- 
counts so as to present false or misleading statements to the 
general body of shareholders and to the public cannot be here 
discussed, it is no doubt clear to every reader of this volume 
that many accounting entries are matters of judgment and 
good faith; and whenever one of these essentials is lacking, 
the company's accounting statements may be technically ac- 
curate and yet may conceal the truth. There are number- 
less variations in method. 

The growing demand for the proper auditing of cor- 
porate accounts has been a strong factor in discouraging their 
juggling. The development of a well-educated financial 
public has also been a factor in restricting such practices. 

"Squeezing" the Minority Stockholders 

As has been indicated before, exploitation is not confined 
to officers and directors as such. It may be an operation per- 
formed by or on behalf of the majority shareholders and 
directed against the minority shareholders. 

Where the majority stockholders deliberately decide to 
exploit the minority, various methods are open to them. One 
frequently employed is to let the corporate business languish 
until it is overwhelmed with debt and a reorganization is 
necessary. In this reorganization the minority interests suffer, 
or perhaps there is a sale under execution at which the ma- 
jority stockholders buy up the whole enterprise at a fraction 
of its value. The same method is sometimes successfully 
employed to "squeeze out" the majority stockholders where 



EXPLOITATION— DIRECTORS— STOCKHOLDERS 



509 



these latter are not in close touch with the business operations 
of the company. Not infrequently inventors have been thus 
crowded out even though they owned more than 50% of the 
outstanding stock of the company and therefore supposed 
themselves safe. 

A crude form of exploiting small corporations is to elect 
the majority stockholders officers of the company and pay out 
its profits to them in the form of excessive salaries. Another 
plan is to make a special contract with another company owned 
by the majority stockholders so that the profits of the first 
company go into the treasury of the second company. 

It is impossible to recount here the many ways in which 
an unscrupulous majority may take advantage of the minority. 
The foregoing paragraphs illustrate the general character of 
the methods used. 

Preventives of Exploitation 

Fundamentally exploitation, even though it may take a 
form which is to some extent sanctioned by common usage, 
is a dishonest process. Men who are thoroughly fair and 
honorable in all their dealings will not be misled into taking 
action that looks toward depriving some of their business 
associates of property or benefits to which they are in equity 
entitled. Men of high standards of personal conduct will not 
descend to using positions of honor and trust for the advance- 
ment of their personal fortunes at the expense of those in 
whose behalf they are supposed to act. Especially is this true 
in the large corporations with their thousands or tens of thou- 
sands of stockholders who are attracted largely by the repu- 
tations of the management and of individual directors. Out 
of the 26,544 shareholders in the New Haven on January 1, 
191 5, 10,813 were women, 3,522 were trustees or guardians, 
and 887 were insurance companies or other corporations. The 
directors of this company could well feel that they were in 



510 FINANCIAL ABUSES AND INVOLVEMENTS 

a position of immense responsibility in handling the funds of 
so many thousands of dependents. 

Integrity of Directors 

The obvious remedy against exploitation, it may therefore 
be suggested, would be for those shareholders who desire 
honest management to elect only directors of unimpeachable 
honor or to refuse to buy the securities of corporations which 
do not have such directors. As a matter of fact, this is the 
fundamental remedy and it is gradually being applied. But 
human nature is too slowly changed to make this remedy 
effective except over a period of generations. It is quite pos- 
sible that in time, as corporate methods become better under- 
stood and standards become better established, attempts at 
exploitation will become comparatively rare. 

Ethical Standards for Directors 

These last remarks lead us back to the difficulties discussed 
in the preceding chapter of determining when and to what 
extent a director is morally justified in taking advantage of 
his position to make profits for himself. Certainly a director 
who realizes that his company is doing well and has good 
prospects is not to be blamed for going into the open market 
and purchasing more of its shares. In so doing he merely 
shows a proper confidence in the future of his company. On 
the other hand, when his business judgment tells him that dark 
days are ahead, is there any reason why he should not sell his 
shares to others whose opinion differ from his own? The 
distinction between what is proper and what is improper is 
perhaps to be found in the principle that the director may buy 
or sell as he chooses, so long as he is not basing his action on 
information that ought properly to be made public. The 
application of that principle is naturally left with each man's 
conscience. 



EXPLOITATION— DIRECTORS-STOCKHOLDERS 5 j T 

Minority Protection by Charter Provision 

Writing in the American Economic Review, Mr. Mulvey, 
Assistant Secretary of State, Ottawa, Canada, first discusses 
the four methods named below of tiring out the minority 
stockholders and leading them to sell at an abnormally low 
price : 

1. Piling up huge undistributed surplus. 

2. Making a contract with a subsidiary company which 

permits the subsidiary to take most of the profits. 

3. Paying out profits in the form of exorbitant salaries. 

4. Selling out the profitable features of the enterprise 

to a new company which is promoted by the ma- 
jority. 

Mr. Mulvey then points out that all these abuses may be 
controlled by the charter or by-laws, and says: 

Salaries may be limited, the dealings with subsidiary 
companies for the purpose of withholding profits may 
be regulated, methods of accounting may be devised 
whereby dividends may not be withheld. A sale of the 
undertaking may be prohibited, except with unanimous 
consent. The shareholder has a contract with the com- 
pany which is made up of the statutes, charter, and arti- 
cles or by-laws. These may be framed so that exactions 
or overbearing methods of the majority may be 
eliminated. 

The objection to charter or by-law provisions placing 
limitations on the operations of the company, as Mr. Mulvey 
suggests, is found in the fact that such restrictions sometimes 
seriously hamper the action of the company. Provisions en- 
tirely harmless at the time they are adopted may be outgrown 
or conditions may so change as to make their operation in- 
jurious. Another objection to the charter or by-law provision 
as a protection of the minority is found in the fact that these 



5" 



FINANCIAL ABUSES AND INVOLVEMENTS 



may be omitted or amended if a sufficient vote can be secured, 
and the protecting provisions be thus swept aside. 

Among the charter or by-law provisions for protecting 
minority stockholders most commonly employed may be 
enumerated the following: 

Cumulative voting, whereby in elections for directors each 
stockholder may cast the whole number of his votes for one 
candidate or distribute them among two or more candidates 
as he may prefer. When this is done the minority stock- 
holders — if they hold any material amount of stock — may 
always secure representation on the board of directors and 
thus protect their interests. 

Classification of stock, each class of stock being given the 
right to elect one or more directors, thus insuring its repre- 
sentation on the board. 

The voting trust whereby a majority of the stock of a 
corporation may be placed in the hands of trustees to be voted 
by them in favor of certain specified persons for directors of 
the corporation. 

Regular audits. These may be prescribed by charter or 
by-laws. They may be annual, quarterly, or held at irregular 
intervals, and serve ^~>th as a check on the management and 
a verification of the .ccounts. 

Publicity as a Means of Minority Protection 

A shareholder in a corporation, large or small, who feels 
that he and his associates are being defrauded, who has a 
clear case and who is willing, with his eyes open, to enter into 
a long and gruelling fight, is likely to find simple publicity a 
highly effective, and, if properly used, a highly legitimate 
method of attack. In a large corporation the campaign of 
publicity may be directed not only toward stockholders, but 
toward the public at large. In a smaller corporation it will 
naturally be confined to people who are directly affected. 



EXPLOITATION— DIRECTORS— STOCKHOLDERS 



513 



Through the use of effective publicity of the best type 
Justice Charles E. Hughes carried through an investigation 
of the life insurance companies which at first was quite insig- 
nificant, but which ultimately brought about, through the pres- 
sure of overwhelming public sentiment, a complete revolution 
in the financial management of the life insurance companies 
and a permanent uplift in standards of business morality. 
More recently, N. L. Amster, of Boston, carried on a cam- 
paign in behalf of the Rock Island stockholders which resulted 
in an agreement to select by general consent a new board 
of directors in whom all the shareholders can place confi- 
dence. 

In 1 9 14, the Interstate Commerce Commission used no 
weapon except publicity in carrying through the investigation 
of the New Haven Railroad, which revealed the true condi- 
tions and led — through pressure of public opinion — to the 
retirement of the old management and the election of an 
entirely new group of directors and other officers. 



01. 



CHAPTER XXV 

INSOLVENCY AND RECEIVERSHIP 

Percentage of Failures 

The number of business concerns which become insolvent 
each year averages a little below i % of the total number. Fol- 
lowing is the record for the last ten years. 





No. of 


No. of Business 


Percentag 




Failures 


Concerns 


Failure 


1905 


11,520 


1,357,455 


.85% 


1906 


10,682 


1,392,949 


77% 


1907 


1 1725 


1,418,075 


.82% 


1908 


15,000 


1,447,554 


1.08% 


1909 


12,924 


1,486,389 


.80% 


1910 


12,652 


i,5i5,i43 


.80% 


1911 


13*441 


1,525,024 


.81% 


1912 


15452 


1,564,279 


.98% 


1913 


16,037 


1,616,517 


•99% 


1914 


18,280 


i,655496 


1.10% 



However, this record does not present a complete picture 
for it does not include numberless instances of financial em- 
barrassment which are settled out of court. Nor does it in- 
clude the still larger number of cases where a business concern 
gradually sinks its capital until finally the enterprise is sold 
or is transferred on some contractual arrangement, thus, bring- 
ing the enterprise into the hands of new men who supply 
fresh capital which is either sunk or makes the business a 
success. Sometimes the process of passing a business concern 
from hand to hand, each new owner losing money until he 
reaches the point where he is glad to hand it over to some 
one else, is carried on over a remarkably long period. 

5H 



INSOLVENCY AND RECEIVERSHIP 



515 



Economic Insolvency 

This condition of being unable so to conduct a business 
that its net earnings will be more than sufficient to cover op- 
erating expenses and fixed charges, may be termed "economic 
insolvency." If the individual partnership or corporation that 
owns a business of this kind becomes unable or unwilling to 
put any further capital into it, and also is unable to make an 
adjustment with creditors or to find a purchaser for the busi- 
ness, then the enterprise may come into the courts and be 
adjudged bankrupt. 

An excellent example of economic insolvency is that of 
the San Antonio Land and Irrigation Company, Limited, 
which went into voluntary bankruptcy on November 4, 191 4. 
The company filed a schedule showing liabilities of over $8,- 
000,000, and assets of approximately $750,000. It had planned 
to build a large reservoir to store water for the irrigation of 
60,000 acres of land. When the plant was completed the 
district suffered from a drought and the main assets of the 
company depreciated greatly in value. 

Economic insolvency is sometimes defined as "the condi- 
tion of a business enterprise that exists when the total value 
of assets is less than the total value of liabilities." In a 
money-losing corporation economic insolvency will sooner or 
later come, although it is often concealed by improper ac- 
counting. 

Technical or Financial Insolvency 

A second type of insolvency is that which exists when 
an enterprise that possesses a greater total of assets than of 
liabilities is unable to meet its obligations. This type is some- 
times called "technical" insolvency or "financial" insolvency. 
It may easily happen that an enterprise which is a great busi- 
ness success may in this sense become insolvent. There have 
been previous references to the two insolvencies and reorgani- 



5 1 6 FINANCIAL ABUSES AND INVOLVEMENTS 

zations of the Westinghouse Electric and Manufacturing 
Company, which has been a big money-making enterprise. 
Various other examples have been given of insolvency due 
to lack of adequate working capital and need not here be re- 
peated. 

This second type of insolvency is probably more common 
than the first. It is due, not to the intrinsic weakness in the 
business, but to errors in its financial management. 

Causes of Insolvency 

The causes of failures, as summarized by the commercial 
agencies, may be grouped in the following two main classes, 
viz., causes for which the management of the failing concern 
may be held responsible, and outside factors over which the 
business can exercise little or no control. 

In the first group we find such causes as lack of capital, 
incompetence on the part of the management, the granting 
of unwise credits, etc. About 80% of all failures are due to 
this group of causes. 

The second class includes such factors as losses by storms, 
floods, and similar disasters, unexpected failures of other con- 
cerns, severe competition, etc. This group of causes accounts 
for approximately 20% of the failures in the United States. 

A few of these factors that are most closely related to the 
subject of financial management will be considered in the next 
few sections. 

Lack of Working Capital 

According to the mercantile agencies, the cause of a little 
more than one-third of the legal insolvencies in the United 
States is "lack of capital." This is rather a vague phrase 
which in the great majority of instances should probably be 
interpreted to mean "lack of working capital." By far the 
greater number of business enterprises can be made successful 



INSOLVENCY AND RECEIVERSHIP 



517 



on a small scale even though their capital may be very limited. 
It is when these enterprises begin to expand and go beyond 
the prudent limits imposed by the small amount of available 
capital, that they tend more and more to transfer working 
assets into fixed assets and finally reach a point, if care is not 
exercised, where they cannot raise the ready cash with which 
to meet maturing obligations. If we were to call the basic 
trouble in such cases "mismanagement of capital," we should 
not be far from wrong. 

Anxiety to Pay Dividends 

A frequent cause of technical insolvency among industrial 
combinations has been excessive anxiety on the part of direc- 
tors to pay dividends. It has previously been pointed out 
that many industrial combinations are started on the basis of 
excessive anticipation of profit, which has been aroused by 
glowing prospectuses, and the organizers feel called upon to 
"make good." Dewing says that in every one of the cases of 
failure cited by him, with the exception of the American Glue 
Company and the possible exception of the American Bicycle 
Company, financial difficulties were not in consequence of over- 
capitalization, as is usually alleged, but the "direct cause of fail- 
ure in every instance was deflection of w r orking capital to the 
paying of interest and dividends. Beneath these, as the funda- 
mental cause, was the lack of judgment ot promoters in placing 
bonds upon an untried industrial enterprise, and the lack of 
conservatism of the early management in paying dividends 
without due regard to sound principles of finance." 

Unfavorable Market Conditions 

Another immediate cause of technical insolvency, which 
is quite frequent among railroad corporations, is inability to 
meet maturing obligations by reason of market conditions. A 
company may be reasonably sound and well able to carry its 



5 i8 FINANCIAL ABUSES AND INVOLVEMENTS 

load of indebtedness and yet may find itself in no position, at 
a given period when market conditions are unfavorable, to 
refund maturing bonds or to put out a new issue. This situation 
will very seldom arise with a corporation that enjoys really 
high credit, but it may easily arise with those that enjoy only 
fair to medium credit. The fact that an obligation falls due at 
an inconvenient time may be regarded as in one sense an ac- 
cidental misfortune, though in another sense the corporation, 
if it had always been well handled, would probably not find 
itself in difficulties wholly by reason of an unreceptive market. 
Though there are other causes for technical insolvencies, 
the three that have been named — deficiency of working capital, 
depletion of cash in order to pay dividends, and maturity of 
bonds or notes under unfavorable market conditions — may be 
picked out as those which are most usual. 

Methods of Procedure in Case of Insolvency 

When a business enterprise is unable to meet its debts and 
is known to be insolvent, four courses of action are open: 

i. The owners of the bonds and other obligations and 
their creditors may agree voluntarily to a "readjustment" or 
settlement of their claims. This can be done only when all the 
creditors are reasonable and have considerable faith in the 
management of the enterprise. In that case, they may pre- 
fer, for their own sakes, that the situation should be kept 
out of the courts and out of public records and that the busi- 
ness should go on with as little disturbance as possible. 

2. The corporation may voluntarily dissolve, divide its 
assets among its creditors, and go out of business, all without 
the intervention of the courts. 

3. The individual, the partnership, or the corporation 
owning the enterprise may be adjudged a bankrupt, and a 
receiver in bankruptcy may be appointed to dispose of the 
assets and distribute the proceeds. 



INSOLVENCY AND RECEIVERSHIP 5 ! 9 

4. The corporation may secure the appointment of a re- 
ceiver in equity whose function is to carry on the business and 
at the same time assist, so far as he can, in working out a 
generally satisfactory plan of reorganization. 

Readjustment of Claims 

The first of these remedies is unusual, except among the 
creditors of small corporations. It requires a degree of har- 
monious action that is almost impossible to bring about among 
a great number of people. The attempt, however, was made 
in July, 191 5, in the case of the Missouri Pacific-Iron Moun- 
tain system under the auspices of one of the great banking 
houses of America, Kuhn, Loeb and Company, who acted as 
readjustment managers. The details of the plan of readjust- 
ment need not, for this purpose, be considered. It was in 
fact quite similar in its general outline to the reorganization 
plans which are discussed in the chapter following. The point 
that interests us here is the fact that in spite of the obvious 
merits of the plan, its remarkably strong backing and the 
general indorsement of the financial press and of financial 
authorities, the final results were disappointing. It proved 
to be impossible to secure the voluntary assent of all, or 
practically all, the security holders, and it was found neces- 
sary to go through the cumbersome and expensive process 
of reorganization. 

A similar attempt was made a few years ago in the case 
of the Hudson and Manhattan Company which operates the 
underground railway system through the Hudson River tunnel. 
In this instance the number of holders of obligations was much 
smaller and the plan of readjustment was successfully carried 
through. This plan is a very common procedure with smaller 
companies and, wherever practicable, is usually by far the most 
economical and most satisfactory method of meeting a con- 
dition of insolvency. Its success, however, is always dependent 



520 



FINANCIAL ABUSES AND INVOLVEMENTS 



upon the presence of a fair degree of mutual confidence and 
good faith among the various parties concerned. 

Origin and Nature of Receivership 

A far wiser and less wasteful method than bankruptcy 
proceedings for handling the condition of insolvency in most 
large corporate enterprises, consists of addressing a petition 
to a court of equity for the appointment of a receiver to carry 
on the business under the supervision of the court, until some 
plan of reorganization is worked out. The petition is referred 
to in some jurisdictions as a "bill in chancery." It may be 
presented by any one of four parties : ( i ) by the corporation 
itself; (2) by the stockholders of the corporation; (3) by the 
secured creditors; (4) by the unsecured creditors. 

Applications from the corporation itself or from its own 
stockholders are rare, and are still more rarely granted. Ap- 
plications from creditors who are friendly toward the cor- 
poration are frequently presented, however, and in such cases 
the court is often requested to appoint one of the officers, or 
some one else close to the management, as receiver. "Friendly 
receiverships," as these arrangements are known, are not 
always warmly favored by the bondholders and other creditors 
who are usually somewhat suspicious of the management that 
is responsible for involving the company in financial diffi- 
culties. 

Conflicting Receiverships 

An application for a receivership may be addressed to any 
court, either federal or state, which has jurisdiction over 
any part of the business of the corporation. As a result it 
has often happened that two or more courts have each ap- 
pointed a receiver and these receiverships have conflicted with 
each other. 

It has been not uncommon for the federal and the state 



INSOLVENCY AND RECEIVERSHIP 52 1 

courts to come into conflict in this manner. The tendency, 
however, has been strong toward putting all receivership pro- 
ceedings that affect interstate corporations into the hands of 
the federal courts; and these courts almost invariably, as a 
matter of courtesy to each other, act in harmony. The judge 
who first appoints a receiver, is usually accorded precedence 
and other judges appoint the same man as receiver of the 
property over which they have jurisdiction. Sometimes the 
incipient conflict is solved by the appointment of an ancillary 
receiver, who is expected to co-operate strictly in harmony 
with the receiver first appointed. 

Dissolution of Insolvent Corporations 

The dissolution of an insolvent corporation and the distri- 
bution of the assets is an uncommon proceeding. It requires 
the consent both of creditors who must trust to the good faith 
of the officers of the corporation in carrying through the disso- 
lution and distribution of the proceeds, and also of the share- 
holders who must be convinced that no other procedure is pos- 
sible. 

It is the feeling among creditors and shareholders alike, 
that those who have managed a corporation which has become 
insolvent, should not be left free to make their own arrange- 
ments for winding up the company, but should be checked 
and supervised by some responsible officer who will unearth 
the facts. It is because of this feeling that the remedies of 
voluntary readjustment and of dissolution are so seldom 
used, and that the remedies of bankruptcy and receivership are 
almost always necessary. 

Voluntary Dissolution 

Dissolutions are not always due to insolvency, but may 
come as the result of pressure of other kinds or as the result 
of a conviction on the part of a majority of the shareholders 



cj22 FINANCIAL ABUSES AND INVOLVEMENTS 

that the corporation, while not actually insolvent or losing 
money, is nevertheless making an unprofitable use of the capital 
invested and is actually tending to deteriorate. Under these 
conditions, it may often be the part of wisdom to bring about a 
dissolution while the company still possesses a valuable surplus. 
A number of special cases of partial dissolution — which might 
also be described as a partial distribution of assets — have arisen 
in the United States recently, due to decrees of the courts re- 
quiring "combinations in restraint of trade" to resolve them- 
selves into their constituent elements. The practical applica- 
tion of these decrees has in many cases involved peculiar diffi- 
culties. 

Instances of Voluntary Dissolution 

Ordinarily there is no special financial skill required in 
order to handle the process of liquidation, which consists simply 
of gradually closing down the business, disposing of the assets, 
and distributing the proceeds to creditors and shareholders. 
Yet even this comparatively simple procedure involves a vast 
amount of detail work. 

In the spring of 19 14 the management of the United States 
Express Company decided that in the face of the competition 
for express business, and particularly on account of the com- 
petition of the newly established parcel post, it would be best 
for the company to liquidate its assets and withdraw from the 
field. After the decision was announced the first step was to 
arrange for the transfer to other express companies of its valu- 
able contracts and of many of its physical assets. Fortu- 
nately, there was little duplication of contracts or facilities 
among the express companies and most of this property could 
be disposed of to the remaining express companies at reason- 
able appraised valuations. 

It was necessary to make complete inventories and this 
proved to be so long a task that in many cases wagons, horses, 



INSOLVENCY AND RECEIVERSHIP 5 2 3 

office furniture, leases, etc., were transferred first and valued 
afterwards. The equipment used by the United States Ex- 
press Company in New York City represented an investment 
of between $350,000 and $400,000. Over 90% of the em- 
ployees of the United States Express Company were taken 
over by the other large express companies. The remaining 
10% were made up largely of employees who were retained 
in the service of the United States Express Company during 
the process of liquidation. 

Origin and Nature of Bankruptcy 

In the early English law an individual was declared bank- 
rupt for the purpose of enabling his creditors to seize upon 
and distribute his assets. In case the assets did not prove suf- 
ficient to meet his debts, he was held personally subject to the 
remaining claims of his creditors, and in default of payment 
was thrown into jail. Within the last 150 years, however, 
the popular and legal conceptions of bankruptcy have been 
greatly modified. 

The purpose of bankruptcy proceedings is no longer 
merely to protect creditors, but also to free the individual 
from a load of debt that has become insupportable and set 
him on his feet again as a useful member of society. There 
are abuses, to be sure, of this modern practice. Cases are 
not unknown, both of individuals and of business enterprises, 
that have gone through bankruptcy proceedings for the prime 
purpose of clearing themselves of the legal obligation to pay 
their debts and afterwards have refused to recognize any 
moral obligation. But these abuses are, after all, compara- 
tively rare. Individuals who have been able to rebuild their 
fortunes, after having gone through bankruptcy, have often 
made it a point of honor to repay in full all the debts from 
which they had legally been freed. 

Bankruptcy proceedings in the United States are governed 



524 



FINANCIAL ABUSES AND INVOLVEMENTS 



by the National Bankruptcy Act of 1898, and the courts having 
jurisdiction are those of the Federal Government. 

Two Kinds of Bankruptcy 

Bankruptcy is of two general kinds, voluntary and in- 
voluntary. The benefits of bankruptcy are open, not only to 
natural persons, with a few exceptions, but also to business 
corporations except those engaged in railroad operation, in- 
surance, or banking. These three lines of business are of such 
general importance that it was thought not to be in the public 
interest to permit their operations to be brought suddenly to a 
close and their assets scattered. The process of winding up 
banking and insurance companies is provided for under the 
National and State Banking and Insurance Acts. The defini- 
tion of "insolvency" as given in the National Bankruptcy Act 
is, from a legal standpoint, peculiar, although it conforms to 
the definition of "economic insolvency" that has been given 
above. A person is insolvent, within the meaning of the bank- 
ruptcy law, "when the aggregate of his property, exclusive of 
any property that he has conveyed, transferred, concealed or 
removed, or permitted to be removed with intent to hinder, 
delay or defraud his creditors, is not, at a fair valuation, suffi- 
cient in amount to pay his debts." An individual or a cor- 
poration being in a condition of insolvency, must then commit 
an "act of bankruptcy" if the person or the corporation is to 
be thrown into involuntary bankruptcy. 

The most common act of bankruptcy is the making of a 
general assignment for the benefit of creditors. As a general 
rule, a voluntary assignment for the benefit of creditors is less 
expensive than bankruptcy proceedings. It requires honor, 
mutual confidence, and good faith, while on the other hand 
bankruptcy procedure is especially valuable in case there is 
any suspicion of misrepresentation or dishonesty. Bankruptcy 
is a harsh and, for most corporations, a fatal remedy for in- 



INSOLVENCY AND RECEIVERSHIP 



525 



solvency. It is, in fact, hardly worth while to attempt to 
rehabilitate a corporation that has gone through bankruptcy. 
It is usually far easier and better to form a new corporation 
which will purchase the assets and proceed to carry on the 
business. 

Receivers' Powers and Duties 

The purpose for which a receiver in equity is appointed, 
is usually quite different from the purpose of a receiver or trus- 
tee in bankruptcy. The latter aims first to take possession of 
all the property of the insolvent individual or concern; next to 
dispose of the property as quickly as is practicable; and third, 
to distribute the cash that has been realized. A receiver in 
equity, on the other hand, has for his function to keep the 
business running as smoothly and with as little loss as possible. 
He may make some changes in methods of administration and 
may properly retrench whenever he can do so without impair- 
ing the efficiency of the property, but in general he carries on 
the business in about the same manner in which any business 
is carried on. He aims not to turn the assets into cash, but 
to keep working as profitably as possible. Not infrequently 
the property of a corporation could not be sold for an amount 
sufficient even to reimburse the secured creditors ; yet as a going 
concern it may be able to earn normal profits. This is the 
case, in fact, with almost all companies that have become 
technically insolvent. They are not, in the first place, properly 
subject to the Bankruptcy Act since their assets certainly 
exceed their liabilities, and to attempt to wind them up would 
be poor policy for every one concerned. The best and most 
common procedure with all such insolvent corporations, as 
well as with banks, insurance companies, and railroads, is to 
arrange — usually through friendly proceedings — for the ap- 
pointment of a receiver to conduct the business while negotia- 
tions for its reorganization are in process. 



52 6 FINANCIAL ABUSES AND INVOLVEMENTS 

The receiver carries on his work under the direct authority 
and supervision of the judge who has appointed him. The 
closeness of this supervision depends to a large extent on 
the personalities of the judge and of the receiver, the general 
practice of the court, and numerous other factors. In gen- 
eral, the receiver makes it a point to secure special authority 
for acts that cannot be regarded as a part of the routine of 
conducting the business. 

Under authority of the court, a receiver may issue obliga- 
tions known as "Receiver's Certificates" which constitute a 
claim on the company's income and assets ranking ahead of 
all other claims. He may secure new equipment, bring new 
blood into the management, find new methods of marketing 
the company's products, and inaugurate new systems of opera- 
tion. He is, in fact, the general manager of the company 
for the time being, with very little restriction upon his actions. 
Sometimes a receiver will remain in control for two or 
three years or more before a satisfactory plan of reorganiza- 
tion is worked out. It has been remarked above that the 
receiver is frequently one of the previous operating officials; 
on the other hand, it sometimes happens that the receiver 
makes so satisfactory a record that he is requested, after the 
reorganization has been completed, to become an operating offi- 
cial and continue to work out the policies which, as receiver, 
he has inaugurated. F. W. Whitridge, for example, after 
successfully operating the Third Avenue Railroad Company 
in New York City as receiver, became and until his death con- 
tinued to be president of the reorganized company. 

Customary Results of Receivership 

It is frequently the case that a corporation which becomes 
insolvent has for several years been running downhill, either 
because of incompetence or exploitation on the part of the 
management, or because the impaired credit of the company 



INSOLVENCY AND RECEIVERSHIP 5 2 7 

has not permitted it to raise new capital with which to bring 
its plant and equipment up to modern requirements. The 
appointment of a receiver, instead of being another step down- 
ward, may prove to be the company's salvation. That depends 
in part, of course, on the character and ability of the receiver. 
If he is a man of ideas and of executive talent, he may quickly 
rejuvenate the organization. As has just been noted, he has 
the power to issue receiver's certificates and thus secure 
funds which had previously been lacking. Sometimes a com- 
paratively small amount of new capital will be enough to put 
a decaying corporation back into a moderately sound condition. 
The receiver has a free hand. If it is possible to do anything 
for the corporation and if he is the man to do it, the results 
of his activities may be a gratifying gain in efficiency and 
earning power. In any event, the receiver should be able to 
hold the organization and the property intact and to turn 
back, after his service is completed, a going and profit-making 
business. 

Ordinarily the receiver takes some part also in an informal 
way in the negotiations for financial reorganization of the 
business and advises with the court as to the plan of reorgani- 
zation that ought to be approved. It is an object of his efforts 
to bring about the reorganization and thus terminate the re- 
ceivership at the earliest possible moment. 

Very infrequently it happens that these customary results — 
maintenance of a going business and financial reorganization 
— are not attainable. And in that case the receivership 
may finally end in a forced winding up of the business. Al- 
though unusual, it is possible even for a railroad, like other 
business enterprises, actually and completely to go out of busi- 
ness. In October, 19 14, the judge having jurisdiction signed 
an order directing the receivers of the Buffalo & Susquehanna 
Railroad to discontinue permanently the operation of trains, to 
take up the company's rails, and to dispose of its assets. It is 



52 8 FINANCIAL ABUSES AND INVOLVEMENTS 

stated that the total population served by this railway, which 
was 86 miles in length, was only about 17,000; consequently 
the railroad was wholly unable to pay its own operating ex- 
penses. At the time when the receiver wound up the business, 
all that was left to the owners of $6,000,000 par value out- 
standing bonds (to say nothing of outstanding preferred and 
common shares) was the scrap value of the rails and rolling 
stock, the right of way, and 23 acres of land fronting on Lake 
Erie. 



CHAPTER XXVI 

REORGANIZATION 

Purpose of Reorganization 

In England the term "reconstruction" is used to describe 
the process that we ordinarily call "reorganization." The 
English word is better chosen as it embodies the idea which 
underlies the whole process; that of tearing down the old 
financial structure and using the materials in a new and 
stronger structure. 

Financial reorganization, in its proper sense, is not merely 
a series of compromises and forced sacrifices imposed upon 
security holders. It is a rearrangement of the company's lia- 
bilities so as to make them conform more closely to the assets 
and earnings. If it is worked out on ideal lines the reorganiza- 
tion may be described as a new financial plan which replaces 
the old plan that has proved faulty. The readjustment of the 
company's finances should enable it to proceed thereafter under 
more favorable conditions and to achieve better results. 

In each reorganization there are one or two specific pur- 
poses that stand out with especial prominence. The specific 
purposes that are most commonly found are the following : 

To raise more capital. 
To reduce fixed charges. 
To simplify the financial structure. 

To give increased facilities for raising capital in future. 
To eliminate unprofitable branches of the business. 
To pay or "refund" pressing obligations. 
To take care of an accumulation of unpaid preferred 
dividends. 

529 



530 



FINANCIAL ABUSES AND INVOLVEMENTS 



The final plan of reorganization must be approved by a 
sufficient number of security holders and must also have the ap- 
proval of the court. The relative influence of the security 
holders, on one side, and of the judge and receiver, on the 
other side, varies greatly in determining the plan of reorganiza- 
tion; and it is probable that in complicated reorganizations, es- 
pecially those of railroads, it is more often necessary for the 
courts to intervene and take an active part in formulating a 
plan than it is in the simpler cases of reorganization, particu- 
larly of industrial corporations. 

Conflicts of Interests in Reorganization 

The various interests which are concerned in a financial re- 
organization may ordinarily be classified in three groups, as 
follows : 

i. The creditors, including both the holders of floating 
debt and the bondholders. 

2. The shareholders, both preferred and common. 

3. The banking houses which are figuring on the under- 

writing of the reorganization plan. 

In a complicated reorganization each one of these three 
groups is subdivided. There may be a number of bond issues 
which have claims that in part conflict with each other. The 
interests of the preferred and of the common shareholders 
are by no means identical. There may be two or more bank- 
ing houses that are working on the reorganization with an eye 
to handling the underwriting. It may often happen, therefore, 
that there is a complex struggle among the various groups of 
interests. On some questions there may be agreements and 
alliances between two or more groups, and on other questions 
the cleavage may be entirely different. 

Naturally the chief influence is exerted by the bondholders, 



REORGANIZATION 



531 



especially by the holders of those issues which are well pro- 
tected by prior liens. 

Next come the holders of the junior lien issues. The bank- 
ing houses are likely to be in close touch with all the different 
groups of bondholders and advise with them. Inasmuch as 
the active assistance of some good banking house is essential 
in order to make any plan a success, the representatives of 
these houses are likely to be consulted and to have a voice 
in determining all important questions. Moreover, they are 
in the advantageous position of an outsider who may be trusted 
to view the situation impartially. 

As for the shareholders in a drastic reorganization, they 
have little to say. Indeed, it sometimes happens that their 
claims to recognition are ruthlessly brushed aside and they are 
practically wiped out of existence. However, as we shall see, 
they are more commonly needed in order to supply the fresh 
cash required for the reorganized company, and for that 
reason are permitted to have some voice in working out the 
reorganization plan. The officers of a failed corporation some- 
times undertake to direct the reorganization but their efforts 
are seldom welcomed. The receiver, as we have seen, some- 
times takes a fairly active, though informal, part in working 
out the reorganization plan. 

Formation of Committees 

In present-day practice one of the immediate results of 
the announcement of insolvency of an important corporation 
is the formation of a number of security holders' committees, 
each one representing a certain security issue. Sometimes one 
committee may represent two or more issues, the interests of 
which are not conflicting. The process of formation of these 
committees is nearly always something of a mystery. They 
seem to spring up sometimes overnight without special au- 
thority. As a matter of fact they are usually self-appointed 



532 



FINANCIAL ABUSES AND INVOLVEMENTS 



and each committee is, in reality, simply a group of individuals 
who have determined among themselves that it is wise and 
proper for them to solicit authority from their fellow security 
holders to act in their behalf. 

In order to secure this authority, it is essential that the 
members of the committee should either be personally well 
known to the security holders or should be connected with im- 
portant firms or banking houses. In large reorganizations 
membership on these committees is regarded as something of 
a prize. The members are frequently allowed generous fees 
for their services and do not, as a matter of fact, have many 
onerous duties. The detailed work is usually handled by the 
secretary of the committee or by counsel. However, it would 
be an injustice to fail to point out that many reorganization 
committees composed of able men devote a great amount of 
time and effort to their work and sometimes, especially in the 
smaller reorganizations, give their services without compen- 
sation. 

Even in the latter case, the fees of attorneys for the 
various reorganization committees must be provided for in the 
reorganization plan. Payments must be made to the managers 
of the reorganization and to the banks or trust companies which 
act as depositories for securities. The receiver's fees, plus the 
fees of the attorneys who advise with him, are nearly always 
heavy. And, finally, there are numerous incidental expenses 
and fees for services of accountants, for advertising and cir- 
cularizing in connection with the reorganization plan, and so 
forth, which aggregate a large amount. The expenses of re- 
organization are so heavy that members of reorganization com- 
mittees are likely to persuade themselves that it makes little 
difference if they include a liberal compensation for themselves. 

The self-appointed committee for a certain group of 
security holders does not always meet with instant acceptance. 
Security holders are likely to be somewhat skeptical. Unless 



REORGANIZATION 533 

most of the large holders are represented in the reorganization 
committee, they are likely to start an opposition committee and 
there may be an active struggle for proxies. If the opposition 
committee is at all successful, there may be later a merger of 
two committees, for it is clearly essential that there should not 
be dissension among any one group of security holders. 

In the normal course of events, after several committees 
have been formed these committees begin to negotiate with 
each other and with the receiver with a view to arranging the 
best possible terms for the interests they represent. It is hardly 
possible for any general agreement to be reached except by a 
protracted series of negotiations and compromises and there 
must be some supreme judge or arbiter. Unless the receiver, 
some official of the company, or some influential person or 
banking house can assume this function and really take charge 
of the whole process of bringing about an agreement, it is 
natural and customary to select from the various security 
holders' committees a group which includes at least one repre- 
sentative of each set of interests that must be taken into con- 
sideration; this group is customarily known as the "Reor- 
ganization Committee. " This is the committee that, in the 
final analysis, devises the plan of reorganization. The various 
security holders' committees may negotiate, but they are likely 
to follow the lead of their representative on the general re- 
organization committee and in reality do little more than give 
their public approval to the final reorganization plan. 

In spite of its drawbacks, including the ever-present pos- 
sibility that not all the security holders' committees will con- 
scientiously represent the interests entrusted to their care, the 
committee method of working out a reorganization plan is in 
most cases the only practical method. In a large corporation 
meetings of the security holders are quite impracticable; and 
if they were held they would be utterly useless so far as work- 
ing out a plan is concerned. 



534 



FINANCIAL ABUSES AND INVOLVEMENTS 



The committee plan might be used more frequently in 
smaller corporations, the security holders of which cannot 
effectively express their will. In a recent instance the majority 
shareholders of an oil-producing company were believed by the 
minority party to have driven the company into bankruptcy. 
The sale of its property and assets had been ordered by the 
Federal Court and a so-called "Reorganization Committee" 
composed of former officials was planning to bid for the com- 
pany at this sale. At the last moment some of the minority 
shareholders appointed themselves a committee, secured the 
co-operation of a good proportion of the outstanding shares, 
employed a capable lawyer and incurred other necessary ex- 
penses which did not constitute a heavy burden on any individ- 
ual shareholder, and presented their objections to the court. 
These objections were sustained, and in the end the committee 
forced the adoption of a new and much more equitable plan. 
In this instance the prompt and courageous action of a few 
small shareholders checked what probably amounted to a con- 
spiracy to obtain full control of the property. 

Procedure in Reorganization 

The first step in a reorganization after some person or 
group of persons — receiver, banking house, reorganization 
committee, or some one else — has been permitted to take 
charge of the process is to bring about a thorough examination 
and analysis of the accounts. It may be extremely unsafe to 
accept without question the accounting statements issued by 
the old management, for it is quite likely that their natural 
effort for several years has been to conceal the company's 
growing financial weakness. Until the actual earnings and 
expenses are definitely determined, no plan of reorganization 
that will hold water can be worked out. The examination 
may be both expensive and lengthy. While it is in progress, 
those actively engaged in the reorganization may carry on 



REORGANIZATION 



535 



negotiations and work out a tentative plan, but no final result 
can be accomplished. 

The second step consists of carrying on or completing the 
negotiations. Inasmuch as most of the members of the security 
holders and reorganization committee who must be consulted 
are likely to be men of affairs devoting only a relatively small 
amount of time and thought to the reorganization scheme, 
these negotiations are troublesome and are likely to cover 
a long period of time before any definite conclusions are 
reached. 

In the meantime, as a third step, the receiver will be con- 
ducting the company with all possible economy. Perhaps, as 
set forth in the preceding chapter, he will be raising new 
capital, reforming the internal organization, and otherwise 
raising the enterprise to a higher plane of efficiency. If the 
company possesses non-essential or non-profit-making prop- 
erty, the receiver may proceed, with the consent of the court, 
to dispose of some of its property. This, again, may be a 
long-drawn-out process. 

The final step, when the reorganization plan has been 
worked out and accepted both by the security holders and by 
the court, is to select and put into execution the best legal 
method of accomplishing the financial rearrangement that has 
been agreed upon. In case the unanimous, or almost unanimous 
consent of the security holders has been obtained, the court 
may declare the plan operative and binding even upon the 
small proportion that have not given their assent. It is more 
frequently necessary, however, to go through the legal form 
of organizing a new corporation — usually with a name very 
similar to that of the insolvent corporation — and to bring 
about a judicial sale of all the property of the old corporation 
to the new corporation. The reorganization committee in that 
case will turn in the obligations of the old corporation in pay- 
ment for the property, and will issue in exchange obligations 



536 FINANCIAL ABUSES AND INVOLVEMENTS 

and shares of the new corporation under the terms that have 
been agreed upon. 

Sometimes stubborn security holders of the old corporation 
who are opposed to the reorganization plan refuse to exchange 
their securities for those of the new corporation. The result 
may not be especially pleasing to them, for they are likely to 
be left holding securities of a company which is non-active 
and for all practical purposes may be called non-existent. 
When the reorganization of the Northern Pacific Railroad 
Company took place in 1896, the holders of some 25,000 
shares refused to exchange them for shares in the Northern 
Pacific Railway Company (the new company). Because of 
their opposition the old company is still kept alive but is, of 
course, inactive. 

Raising Fresh Capital 

Usually the most urgent problem in a reorganization is to 
bring in fresh capital, either for the purpose of making addi- 
tions and betterments in the fixed assets, or more commonly 
for the purpose of providing adequate working capital. In 
either case it is necessary, in almost every reorganization, to 
secure a considerable amount of cash. If the company had 
been well supplied with cash it would not presumably have 
become insolvent. But the fact that a company is in receivers' 
hands is naturally no recommendation to prospective pur- 
chasers of its securities, and the problem of raising cash is 
therefore not only urgent but often extremely difficult. It can 
be solved only by enforcing drastic sacrifices on security 
holders. There are three possible methods of raising new 
capital or of securing an equivalent reduction in current lia- 
bilities : 

1. By bringing out new issues of bonds or shares which 
are well secured and are offered on terms particu- 
larly favorable to purchasers. 



REORGANIZATION 537 

2. By levying assessments on bond or share holders. 

3. By inducing the current creditors, or some of them, to 

accept funded obligations in payment of the amounts 
due them. 

In case the insolvent company's credit has not already been 
used to the limit, it may be possible to bring about some rear- 
rangement of claims upon assets and earnings which will leave 
room for the issuance of new securities. These securities may 
then be sold at a heavy discount and thus the cash most 
urgently needed may be obtained. 

The second method of raising cash is through assessment. 
In nearly every reorganization the common shareholders are 
requested to pay some assessment in order to secure any hold- 
ings in the reorganized company. The same requirement is 
frequently imposed upon the preferred shareholders and is 
sometimes imposed even upon the junior bondholders. It may 
seem strange that a bondholder or even a preferred shareholder 
should be compelled to pay out fresh money in order to hold 
an interest in the company; but the truth is that any security 
holder who is not amply protected by marketable assets is 
likely to face this experience. If he resists the proposal a new 
company is organized which, at the judicial sale, will turn in 
the prior lien securities in payment for all the property of 
the company. This automatically wipes out the junior bond- 
holders — unless they choose to raise the capital with which to 
pay off the prior lien holders, in which case they will hold the 
whip-hand. The junior bondholders or shareholders are thus 
left with the clear alternative of either giving up their previous 
investment without any further effort to protect and redeem 
it, or of paying the assessment. 

The question as to whether a shareholder should or should 
not pay his assessment is always one to be studied with much 
care. Naturally the reorganization managers will endeavor to 



538 FINANCIAL ABUSES AND INVOLVEMENTS 

make terms that will be at least fairly attractive in order to 
insure that the money which is required shall be forthcoming. 
For this reason it is usually profitable for shareholders to pay 
up their assessment. Daggett states that in almost all cases 
of railroad reorganization the price of the securities obtained 
by the assessment payer was within six months nearly equal 
to the previous market quotation plus the assessment. In 
practically every case later quotations have gone much higher. 
The increase in value "has abundantly justified the payments 
which stockholders were asked to make." Probably the most 
drastic assessment on record is that of the Houston and Texas 
Central Railroad Company in 1897, which amounted to 73% 
on the common shares. 

The third method of increasing cash resources — -that of 
inducing the current creditors to accept long-term securities 
in settlement of their claims — is practicable only when the in- 
solvent company is fundamentally prosperous and has been 
brought into difficulties merely through a temporary shortage 
in working capital. In both the Westinghouse reorganizations 
the holders of floating debt were easily persuaded to take long- 
term notes and bonds in payment, for they were convinced of 
the company's inherent soundness. In the first reorganiza- 
tion of 1 89 1 the company's $3,000,000 in floating debts were 
replaced largely by stock issues. 

Reducing Fixed Charges 

In the majority of cases of insolvency the trouble has 
arisen primarily because the company had a larger load of 
fixed charges than its income would permit it to carry. That 
being the case, the only safe and correct course in reorganiza- 
tion is to cut down these charges. It is useless to continue 
them unless the company's difficulties are partly temporary; 
for to do so would be simply to invite a new insolvency. 

One of the simplest and most severe cases of cutting down 



REORGANIZATION 



539 



fixed charges is that of the reorganization of the Northern 
Pacific Railroad Company in 1875. The company's line was 
at that time still under construction and its earnings were less 
than y 2 of 1% on its funded debt. There seemed to be no 
immediate prospect of increasing the earnings and it was 
therefore determined that all fixed charges should be eliminated. 
All outstanding bonds were replaced by preferred shares ; float- 
ing debt was also exchanged for preferred shares; and old 
common shares were replaced by new common shares. 

Daggett points out that out of seven railroad reorganiza- 
tions in the period from 1893 to 1898, every one showed a de- 
crease in fixed charges averaging 31%. He suggests that 
experience shows the advisability of keeping in view, in the 
rearrangement of fixed charges, the five following principles : 

1. The maximum fixed charges after the reorganiza- 

tion is completed should not exceed the absolute 
minimum of net earnings. 

2. As large a proportion as possible of the charges 

should consist of interest on bonds, avoiding sink- 
ing funds, guaranteed dividends, rentals, and the 
like. 

3. The losses should fall most heavily on the junior 

security holders generally, leaving the first lien 
securities — unless the reorganization is exceedingly 
drastic — practically untouched. 

4. While fixed charges should be cut, the nominal value 

of the new securities received by security holders 
in the old company should be reduced as little as 
possible. 

5. Bondholders whose claims are scaled down should be 

given a corresponding chance to participate in fu- 
ture increases of earnings.* 



'Daggett's "Railroad Reorganization," pp. 357-362. 



54o 



FINANCIAL ABUSES AND INVOLVEMENTS 



If the junior bondholder who is asked to accept a reduc- 
tion in the principal and possibly in the rate of interest of his 
holdings, is at the same time given preferred and common 
shares up to the full par value of his former bondholdings, or 
perhaps a little above, he is inclined to accept the reduction 
much more readily. He may feel, quite properly, that there 
is at least a chance of his recovering in future all the capital 
that he has lost. 

As to industrial reorganizations, Dewing has averaged the 
results of 27 companies, and finds that fixed charges were re- 
duced on the average about 25%. This percentage probably 
measures fairly well the excessive amounts of bonded and 
other obligations which were issued above the limits of pru- 
dence under the old financial plan. 

The tendency on the whole has been more and more 
strongly toward avoiding half-way measures in reorganizations 
and toward putting the corporation on its feet financially so 
that it will not within a short time come back into the hands of 
the financial surgeons. To illustrate this tendency, an interest- 
ing parallel may be drawn between the first reorganization of 
the Erie Railroad in 1859 and its reorganization in 1895 by 
which time the present-day methods and principles of reorgani- 
zation had become well recognized. In the first reorganization 
fixed charges were not reduced, preferred shares were given in 
exchange for the unsecured indebtedness, the second mortgage 
which was about to fall due was extended, and an assessment 
of 2y 2 °/o was levied on both preferred and common shares. 
The position of the road was not much stronger after the reor- 
ganization than it had been before, and the money paid in by the 
shareholders was dissipated without permanent benefit either 
to the corporation or to themselves. The reorganization of 
1895, on tne other hand, lowered fixed charges, procured am- 
ple cash by assessments on the shareholders, and gave shares 
rather than bonds in exchange for the new cash raised. 



REORGANIZATION 



541 



Effect on Financial Structure 

One customary result of reorganization is an increase in 
capitalization. At first glance this may seem surprising, but 
it is the necessary result of the policy of compensating the old 
security holders for their sacrifices by giving them some form 
of claim on the future earnings of the corporation. Junior 
bondholders are usually asked to accept a percentage of new 
bonds plus a percentage of preferred shares, the new securities 
having a total nominal value at least equivalent to the nominal 
value of the bonds they formerly held. The preferred share- 
holder is perhaps asked to pay an assessment and accept new 
securities consisting of preferred and common shares. The 
common shares may be reduced or wiped out, but more often, 
upon payment of assessment, are replaced by shares of not 
greatly reduced nominal value. In general, the tendency is 
strongly toward reducing bond capitalization and increasing 
the share capitalization more than proportionately. 

Another customary result in large corporations is the sim- 
plification of the company's financial structure. In the years 
preceding reorganization the company has in all probability 
put out various issues of bonds, preferred shares, and com- 
mon shares, some of which may have conflicting or uncertain 
claims. Reorganization gives an opportunity to replace these 
various small issues by a few large issues. At the same time, 
increased facilities for raising capital in future are often pro- 
vided. The new issues are made large enough to provide for 
the immediate needs of the reorganized company, with the 
proviso that additional bonds may be sold under the same mort- 
gage on fulfillment of the conditions, set forth in the deed of 
trust. Through this simplification and provision for future cap- 
ital requirements the company's financial structure may be 
brought into line with the best present-day practice. This is 
often one great advantage of reorganization. 

Another advantage frequently afforded by a reorganization 



542 



FINANCIAL ABUSES AND INVOLVEMENTS 



is the opportunity to eliminate unprofitable branches or de- 
partments. Sometimes the bondholders who are secured by a 
mortgage or a branch or an isolated plant are bluntly told 
that they may take the property which is not wanted by the 
parent corporation. More often, the fact that the property to 
which they have a claim is not essential, is driven home and 
they are forced to agree to a considerable reduction in their 
claims, which may be sufficient to put the outlying branch or 
plant on a profitable basis. Reorganization is apt to be car- 
ried on in a cold-blooded way by financial men who are im- 
pressed only by results that have actually been achieved. Fre- 
quently the main difficulty with a business that has become in- 
solvent has been overoptimism and overexpansion on the 
part of its management. Wherever that is the case, a reor- 
ganization which eliminates these outside ventures or reduces 
the expense of conducting them may prove of great and lasting 
benefit to the corporation. 

Reorganizations for Special Purposes 

An extremely simple reorganization which did not in any 
way affect the financial structure of the company was that of 
the American Woolen Company of New Jersey in August, 
191 5. This reorganization is fully explained in the following 
extract from the official statement issued at the time : 

The American Woolen Company is essentially a New 
England organization. With but one exception all its 
plants are located in New England; its executive head- 
quarters are in Boston; its largest mills are situated in 
Massachusetts; a very large number of its stockholders 
are Massachusetts people; the bulk of its taxes is paid in 
Massachusetts; and most of its financing is done in 
Massachusetts. For these and other reasons, including 
important advantages offered by the corporation and 
taxation laws of Massachusetts, it is the opinion of your 
directors that the interests of your Company as a corpo- 



REORGANIZATION 543 

ration and of the stockholders individually will be best 
served by rechartering the Company as a Massachusetts 
corporation. 

It is proposed that the new corporation shall issue 
amounts of preferred and common stock equal to those 
now outstanding of the New Jersey corporation, to wit, 
$40,000,000 of preferred stock and $20,000,000 of com- 
mon stock; and that the relative rights and interests of 
preferred and common stockholders with respect to 
preferences, dividends, voting rights, etc., shall be the 
same in the Massachusetts corporation as they now are 
in the New Jersey corporation. The final result of the 
proposed proceedings will be that the assets and good- 
will of the New Jersey corporation will be vested in the 
Massachusetts corporation, which will issue its preferred 
and common stock as above stated. The directors and 
other officers of the Massachusetts corporation will be 
those of the New Jersey corporation, with the exception 
of two inactive members of your board, one of whom is 
a resident of New Jersey. In other words, with the ex- 
ception of some minor differences rendered essential by 
the statutes of Massachusetts, the rights and interests of 
the stockholders in the new corporation will be those in 
the old corporation. 

A not uncommon reason for a simple reorganization is the 
desire to take care of accumulated unpaid dividends on pre- 
ferred share issues. When a corporation, after a long period 
of small profits during which it has been impossible to keep 
up payments of preferred dividends, reaches a stage of pros- 
perity that appears likely to be lasting, the common share- 
holders are often impatient at the prospect of continuing for 
some years the slow process of paying up the back dividends 
while in the meantime the common shareholders receive 
nothing. On the other hand, the preferred shareholders, if 
they feel confidence in the continued large earning power of 
the company, may be entirely willing to accept securities in 
lieu of cash in settlement of their dividend claims. In 19 14 



544 



FINANCIAL ABUSES AND INVOLVEMENTS 



the directors of the Western Power Company formulated a 
plan of this kind for funding back dividends amounting to 18% 
which had accumulated on the company's $6,000,000 of 6%. 
preferred stock. In substance the plan provided for a new 
corporation — the Western Power Corporation — which would 
have $7,080,000 preferred shares at a par value of $100 per 
share, and 146,700 common shares without par value. $118 
in new preferred was offered for each $100 of the old pre- 
ferred ; while the new common was exchanged share for share 
for the old common. 

A very simple method of reorganization when a going cor- 
poration needs more cash, is to persuade all the shareholders to 
turn back to the company a given proportion of their holdings, 
and then to resell this treasury stock for cash. This is a method 
commonly used among textile mills where the issuance of 
bonds is objectionable because of their bad effect on the bank 
credit of the companies operating in this field. The plan is 
obviously unworkable if any shareholder objects, and is applic- 
able therefore only to corporations having but a small num- 
ber of shareholders. 

Reorganization to Secure Control 

A manufacturing corporation in a small eastern city had 
been built up over a long period of years by its president and 
general manager. It was originally owned by the president 
as an individual but later was incorporated and shares were 
taken by some of his leading officials. x\t the time of his death 
the business was capitalized at $600,000, of which the president 
owned $489,000, the general manager — who had become the 
active operating head of the plant — $80,000, and the remain- 
ing shares were scattered among other operating officials. 
After the president's death his estate was handled by trustees 
who were desirous of putting the property into a well-secured 
form and did not wish to take any active part in the manage- 



REORGANIZATION 



545 



merit of the business. On the other hand, the general man- 
ager was anxious to obtain control. Under these conditions, 
it was determined that the shares held in the president's estate 
should be exchanged in part for bonds of the corporation and 
in part for preferred shares. Inasmuch as the executors of 
the estate desired to withdraw a large part of the capital from 
the business in order to make a more diversified investment, 
it was further determined that the corporation and the execu- 
tors should co-operate in carrying through a sale, to outsiders, 
of the preferred shares held by the estate. 

A new corporation was then organized which issued $200,- 
000 in bonds, $200,000 in preferred shares, and $200,000 in 
common shares, and which gave its securities in exchange on 
an agreed basis for the common shares of the old company. 
The estate was still left with a small block of common shares 
upon which the general manager took an option. In the mean- 
time, in order to secure his control, a voting trust agreement 
was entered into which gave the general manager full power 
to name a majority of the board. A sales campaign was then 
started to dispose of the preferred shares. Inasmuch as the 
corporation took part in the campaign, it was conducted in 
such a manner that no injury to the credit of the corporation 
resulted. It is understood to have been entirely successful. The 
general manager has exercised his option for the purchase of 
the estate's holdings of the common shares ; and the final result, 
therefore, is highly satisfactory to all parties concerned. 

The various purposes of reorganization are so numerous 
that they cannot all be discussed. The general principles set 
forth and illustrated in this chapter, however, can always be 
utilized. Unless there is deliberate unfairness or stupidity on 
the part of some of the interests concerned, it is always pos- 
sible to work out a scheme of readjustment or reorganization 
that will serve the best interests of all parties. 



INDEX 



Acceptances, III, 391, 407 
Accounting, 

relation to financing, 3 
Accounts, 

commercial, advances on, 407-409 

instalment, advances on, 407 

juggling, 507 

trade, 115 
Accounts payable, in 
Accounts receivable, 

as collateral, 120 
Advertising agency, 

financing an, 226 
Agreements, syndicate, 345 
Aktiengesellschaft, 23 
American Malting Corporation, 

estimation of earnings, 186 
American Telephone and Telegraph 
Company, 

number of stockholders, 37 
American Woolen Company, 

reorganization of, 542 
Amortization, 

principal methods of, 163 
Annual report, 

American practice, 35 

English practice, 36 
"Assembling" a proposition, 240 
"Assenting" stock, 85 
Assessments, 

in reorganization, 537 
Assets, 

adjustment of capitalization to, 
189 

copyrights, 191 

good-will, 191-197 

increment of, 468 



intangible, depreciation of, 426 
intangible, represented by com- 
mon stock, 75 
patents, 191 
"quick," 357 

distinction from cash, 405 
relation to security issues, 212, 

218 
stock preferred as to, 73 
tangible, represented by bonds 

and preferred stock, 75 
three divisions of, 218 
working, 
converting into cash, 405 
relation to gross sales, 384 
Associations, 

under deeds of trust, 20 
Auction, 
England, "Model Auction 

Clause," 309 
selling securities at, 308 



B 

Bank collateral, 120 

Bank credit (See also "Credit") 

abuse of, 117 

form of borrowed capital, 116 
Bank loans, 

factors considered, 123 
Bankruptcy, 

kinds of, 524 

origin and nature of, 523 
Bankruptcy Act, 524 
Banks, 

calculating extension of capital, 
368 

source of capital funds, 203 



547 



54B 



INDEX 



Betterment expenses, 

concealment of, 429 
Betterments, 

charged to operating expenses, 
428 

investing in, 370 

two classes of, 431 
Bill in chancery, 520 
Bills of exchange, 394 
Bills of lading, 

as collateral, 121 
Bills receivable, 

as collateral, 120 
Bonds, 

adaptation of, to market, 209 

as collateral, 120 

assessment on, in reorganization, 

537 

bearer form, 140 

"closed," 136 

collateral trust, 147 

convertible, 158 

corporate, 137 

coupon form, 140 

debenture, 149 

denomination of, 138 

equipment trust, 145 

form of long-term borrowing, 131 

income, 154 

issues, 
choosing the right kind, 212 
handling of by brokers, 320 
relation to gross earnings, 497 

"limited open end," 136 

mortgage, 141 

Erie Railroad, 142 

"open," 136 

participating, 158 

registered, 140 

safeguarding of, 170 

security behind, 140 

selling (See also "Selling secur- 
ities") 
on stock exchange, 328 



special provisions and forms of, 
219 
Bonus in stock, 91 
Borrowing money, 7 (See also 

"Capital") 
"Broken lot" of stock, 67 
Brokerage, 322 
Brokers, 

as speculators, 332 

commission of, New York Stock 
Exchange, 330 

handling of security issues, 320 

limitation of sale through, 324 

obligations of, 322 

requirements of, 326 
Budgets, 482-488 

cash, 488 

classification of expenses, 488 

continual revision, 485 

income, 487 

income vs. cash basis, 485 

monthly, 487 

nature and types of, 482 

objections to, 483 

use of, 482 
Business, 

diverged to other companies by 
officers, 503 

voiume of, 384 
Business finance (See "Financ- 

ing") 
By-laws of corporation, 33 



Calculating income, 417 
Calumet and Hecla Mining Com- 
pany, 
dividend record, 449 
Canada, 
corporations, expense of organiz- 
ing, 58 
voting power of preferred stock, 
79 



INDEX 



549 



Capital, (See also "Capital funds") 
additional, 209 
adjusted to earnings, 299 
advantages of borrowing, 105 
borrowed, 

forms of, no 

long-term, 131-171 

long-term, bonds, 131 

long-term, mortgages, 131 

proportions of, 108 

short-term, 105-130 

short-term, bank credit, 116 

trade-credit as form of, in 
calculating extension of, for a 

bank, 368 
distinction between owned and 

borrowed, 65 
estimating requirements, 354 
fixed, 355 

calculating, 363 

relative amount of, to working, 
378 
investing in betterments, 370 
investing in extensions, 364 
owned, 65-104 

percentage of net returns to, 182 
raising cash, in reorganization, 

536 
"revolving," 355 
surplus as a source of, 478 
total, relation to working, 490 
working, 355 

affected by period of manufac- 
ture, 381 

affected by terms of purchase, 
388 

affected by terms of sale, 392 

affected by turnover, 384 

calculating requirements for, 
380-414 

effect of seasonal changes, 412 

factors that affect, 361 

factors to be considered, 380 

for instalment selling, 401 



in new proposition, 247 
lack of, 516 

necessity for adequate, 357 
relative amount of, to fixed, 
378 
Capital funds, 
banks and institutions as a source, 

203 
investing public as a source, 203 
investment associations as a 

source, 204 
investment of, 354-379 
sources of, 201-228 
speculative public as a source, 205 
Capitalization, 172-200 
adjustment to assets, 189 
adjustment to earnings, 184 
basis of, 173 
definition of, 172 
investment as basis, 175 
of development expenses, 178 
of earning power, 179-186 
of initial expenses and losses, 177 
of organizing expenses, 178 
of public service companies, 199 
of surplus, 197 

percentage of net returns to, 182 
railroad, per mile, 215 
recapitulation by stock dividends, 

197 
relation to gross sales, 181 
Cash, 
budgets, 488 

converting working capital into, 405 
paying dividends with, 453 
Cash resources, 493 
Central of Georgia Railway Com- 
pany, 
income bonds, 155 
Centralization, 

avoidance of, 62 
Certificates, stock, 86 
in "bearer" form, 87 
"registered," 87 



550 



INDEX 



Chain stores, 

human equation in, 188 
Charters, corporation, 27 

revision to prevent exploitation, 

5ii 
Claflin, H. B., Company, 

credit of, 119 

notes of, 119 
Claims, 

readjustment of, in case of in- 
solvency, 519 
"Clayton Bill," 40 
Collateral, 

accounts receivable as basis, 120 

basis for bank credit, 120 

bills of lading as basis, 121 

bills receivable as basis, 120 

bonds as basis, 120 

cotton as basis, 121 

live stock as basis, 122 

merchandise as basis, 120 

personal property as basis, 121 

stock as basis, 120 

warehouse receipts as basis, 121 

wheat as basis, 121 
Collateral trust bonds, 147 
Colorado Fuel and Iron Company, 

management of, 62 
Combinations (See also "Promot- 
ing combinations") 

basis of, 275 

difficulties of forming, 269 

English, typical, 279 

fields for, 267 

forming, to secure control, 286 

"horizontal," 265 

industrial, development of, 265 

making them successful, 289 

preliminary investigation, 273 

promotion of, 265-290 

small, analysis of, 282 

"vertical," 265 
Commercial accounts, 

advances on, 409 



Commercial Credit Company, 

loans against notes, 410 
Commercial loans, 

factors considered, 123 
Commercial Security Company, 

method of financing instalment 
accounts, 408 
Commissions, 

charged by underwriting syndi- 
cates, 348 

on sale of securities, 322 
Committees, 

formation of, in reorganization, 
531 
Common stock, 

adequate income for dividends, 217 

distinction from "ordinary 
shares," 70 

effect of limitation to, 214 
Companies Act, 

Dominion of Canada, 79 
Compensation, 

of directors, 41 
Competition, 

regulation of, by combination, 265 
Consolidated Cotton Duck Com- 
pany, 

syndicate operations with, 351 
Consolidations, 281 (See also 
"Combinations" and "Pro- 
moting combinations") 
Contracts, 

instalment, 399 

that benefit officers, 502 

with directors, 43 
Control, 

reorganization to secure, 544 

securing, by officers, 504 
Conversion, 

preferred into common, 81 
Convertible bonds, 158 
Copyrights, 

valuation of, 191 
Corporate deeds of trust, 133 



INDEX 



551 



Corporate form, 45-63 

advantages of, 54 

disadvantages of, 56 

efficiency of, 59 

favors exploitation, 499 
Corporations, 25-44 (See also "Cor- 
porate form" above) 

advantages of corporate form, 

54 
by-laws, 33 
charter, 27 

choosing the security issue, 212 
classes of stock, 30 
close, 48 
disadvantage of corporate form, 

56 
dissolution of insolvent, 521 
distinction from other forms, 

17 

expense of organizing, 58 
fiction of corporate entity, 26 
governmental control of, 57 
holding companies, 49 

legality of, 51 
illegal combinations, 50 
importance of, 45 
internal regulations of, 33 
name, 29 

non-competitive, 51 
"non-stock," 47 
open, 48 

operation in different jurisdic- 
tions, 31 
operation in foreign countries, 32 
origin of, 25 
ownership, 

continuity of, 56 

distribution of, 54 

liability of, 54 
principal business office, 30 
purposes, 29 

smaller, selling stock of, 208 
small, the number of, 46 
subsidiary, 52 



transfer of ownership, 54 
trusts, 50 
Cotton as collateral, 121 
Credit, 
bank, 116 
abuse of, 117 

abuse of, Claflin, H. B. Com- 
pany, 119 
basic principles of, 123 
statements required, 124 
unwritten rules of, 125 
"lines" of, 407 
of a corporation, 57 
trade, 11 1 
Creditors, exploitations of, 507 
Cumulative, preferred stock divi- 
dend, 71 
Customers, selling securities to, 
294 



Dealers, security, 

classes of, 319 
Debenture bonds, 149 
Debentures, perpetual, 219 
Deeds of trust, 

association under, 20 

corporate, 133 
Deferred ordinary shares, English, 

70 
Deferred shares, English, 83 
Depreciation, 

reserves for, 423 
Development, 

expenses of, 178, 354 

of industrial combinations, 265 
Diminishing returns, 

law of, 367 
Directors, 

as corporate officers, 39 

compensation of, 41 

contracts with, 43 

duties, 37, 63 

ethical standards, 510 



552 



INDEX 



Directors — continued 

exploitation by, 507-513 

integrity of, 510 

juggling accounts, 507 

legal status of, 42 

"ornamental," 40 

rights of, 37 
Dissolution, 

of insolvent corporations, 521 

voluntary, 521 
Distribution, wide, of stock, 206 
Dividends, 435-464 

average rate of, 437 

cash requirements for, 451 

common stock, adequate income 
for, 217 

cumulative, on preferred stock, 

7i 
extra, 441 

from accumulated surplus, 450 
funding of, 73 
lack of prudence in paying, effects 

of, 455 
legal rules affecting, 463 
non-cumulative, 71 
paying, cause of insolvency, 

517 
paying with borrowed cash, 

453 

percentage of earnings devoted 
to, 438 

policies of important companies, 
446 

preferred stock, rights as to, 80 

prior claim, 73 

rate on preferred stock, 71 

regularity of, 440 

rule for maintaining regularity of 
rate, 444 

scrip, 457 

stock, 459 

recapitalization of surplus, 197 
Dominion of Canada Trust Cor- 
poration, 



stockholders' views on voluntary 
dissolution, 521 
Drafts, 
accepted, 396 
terms of, 390 



Earning power, 
capitalized, 179-186 
estimates of, 186 
Earnings (See also "Income") 
adjustment to, of capitalization, 

184 
correct relation to outstanding 

securities, 212 
gross, honesty in stating, 418 
gross, relation to stock and bond 

issues, 497 
percentage of, devoted to divi- 
dends, 438 
Eastman Kodak Company, 

dividend record, 447 
Efficiency of corporate form, 59 
Employees, 

selling securities to, 294 
Engineering firms, 

as promoters, 252 
Entity, fiction of corporate, 26 
Equation, human, in chain stores, 

188 
Equipment trust bonds, 145 
Erie Railroad, 
mortgage bonds of, 142 
short-time notes of, 128 
European system, 
financing merchandise purchases, 
114 
Expenses, 

initial, capitalization of, 177 

of development, 354 

of organizing corporation, 58 

in Canada, 58 
operating, 428 

determination of, 421 



INDEX 



553 



Exploitation, 

abuses by subordinate officers, 
500 

a common evil, 505 

by directors and majority share- 
holders, 507-513 

by officers, 499-506 

contracts that benefit officers, 502 

corporate form favors, 499 

differing from fraud, 499 

divergence of business to other 
companies, 503 

enlarging circle of "insiders," 507 

exorbitant salaries, 501 

juggling accounts, 507 

misleading statements, 508 

misuse of inside information, 504 

of creditors, 507 

preventives of, 509-513 

publicity, power of, 512 

"squeezing" the minority stock- 
holders, 508 

"unloading" and securing control, 
504 
Exports, 

effect on working capital, 393 

financing of, 394 



Federal Reserve Bank, 

rediscounting by, 125 
Fees paid in selling securities, 325 
Financial crisis, 

short-term notes as feature of, 
128 
Financial insolvency, 515 
Financial plan, 219-228 

of advertising agency, 226 

of incorporated partnership, 221 

of promoter, 255 

of railroad, 224 

simplicity desirable, 6, 228 
Financial standards, 489-498 

analysis based on, 498 



cash and cash resources, 493 

need of, 489 

operating ratios, 495 

relation of working capital to 
total capital, 490 

stock and bond issues in relation 
to gross earnings, 497 

turnover, 495 
Financial statements, 

basis for bank credit, 124 
Financing, 

an advertising agency, 226 

an incorporated partnership, 221 

a railroad, 224 

elementary rules of, 9 

export shipments, 394 

instalment sales, 398 

preliminary, by promoter, 244 

simplicity of, 6, 228 

unskilful, 1 
Fixed capital, 355 

calculating, 363 

relative amount of, to working, 
378 
Fixed charges, 

reducing, in reorganization, 538 
"Floor traders," 

stock exchange, 332 
Foreign countries, 

corporation operating in, 32 
Forms of business enterprises, 11- 

24 
Founders' shares. 

use of in England, 83 
Fraud (See "Exploitation") 
Fund, surplus, 465 
Funding of unpaid dividends, 73 
Funds, 

foresight in providing, in promo- 
tion, 246 

"rainy-day," 475 
G 
German law, 

business organization under, 23 



554 



INDEX 



Gesellschaft mit Beschrankter haf- 
tung, 23 

Good-will, valuation of, 191-197 

Governmental control of corpora- 
tions, 57 

Gross earnings (See "Earnings") 

Gross sales, 
percentage of, to capitalization, 
181 

H 

Holding companies, 49 
advantages of, 52 
legality of, 51 



Illegal combination, 50 

Imperial Tobacco Company, Ltd., 

number of stockholders, 84 
Income (See also "Net Income") 

application of, 9 

budget, 491 

formula for, 415 

statements, examples of, 415 

steps in calculating, 417 
Income bonds, 154 
Industrial combinations, 

development of, 265 
Industrials, preferred stock of, 75 
Information, inside, 

misuse of, by officers, 504 
Inheritance, 

as source of surplus, 467 
Initial expenses, 

capitalization of, 177 
Insolvency, 514-528 

causes of, 516 
paying dividends, 517 

economic, 515 

financial, 515 

lack of working capital, 516 

methods of procedure in case of, 
518 



readjustment of claims, 519 

technical, 515 

types of, 515 

unfavorable market conditions, 
517 
Instalment accounts, 

advances on, 407 
Instalment contract, 399 
Instalment sales, 

financing of, 398 

three ways of financing, 404 

working capital required, 401 
Institutions as source of capital 

funds, 203 
Intangible assets, 

represented by common stock, 75 
International Cotton Mills Corpor- 
ation, 

juggling accounts, 547 

syndicate agreement with, 352 
Interstate Commerce Commission, 

report on status of N. Y., N. H. 
& H. R.R., 40 
Investigation, 

preliminary, in promoting com- 
binations, 273 

scope of, by promoters, 234 

stages of, in promoting, 230 

thoroughness of, in promoting, 
231 
Investing public, 

as source of capital, 203-212 
Investment associations, 

as source of capital funds, 203 
Investment of capital funds, 354- 

379 
Investments, 
as basis of capitalization, 175 
in extensions, 364 
in betterments, 370 
in securities, 374 
in side lines, 372 
permanent and transient, 8 
upon an uncertainty, 234 









INDEX 



555 



Joint-stock companies, 19 



"Lambs," as speculators, 333 
Latin law, 

business organization under, 22 
Law of diminishing returns, 367 
Leases, 

advances on, 408 
Legal rules affecting dividends, 463 
Legal status, 

of directors, 42 

of promoter, 256 
Lehigh Valley Railroad Company, 

betterments, concealment of, 428 
Liabilities, 

current, relation to current assets, 
406 

quick, 357 
Liability of partly paid stock, 90 
Loans (See also "Collateral" and 
"Credit") 

bank, factors considered, 123 

commercial, factors considered, 
123 
London Stock Exchange, 331 

M 

Maintenance, 

reserves for, 425 
Management of combinations, 289 
Management shares, 

use of in England, 83 
Manufacture, 

length of period of, 381 
Manufacturers' Commercial Com- 
pany, 

method of financing accounts re- 
ceivable, 409 
Market, 

adaptation of securities to, 209 

making a, on stock exchange, 334 



Meetings of stockholders, 99 
Merchandise as collateral, 120 
Minority stockholders, 

squeezing of, 508 
Montana Power Company, 

stock of, 85 
Mortgage bonds, 141 
Mortgages, 

advances on, 408 

form of long-term borrowing, 

131 
ratio of, to value, 143 
Mount Vernon-Woodberry Cotton 

Duck Company, 
example of promotion, 242, 262 

N 

National Bankruptcy Act, 524 
National Biscuit Company, 

policy of, 365 
National Cordage Company, 
discrepancy between investment 

and actual value, 176 
misuse of inside information by 

officers, 504 
stock of, not adapted to market, 21 1 
National Starch Manufacturing 
Company, 
promotion of, 276 
Net income (See also "Income") 
determination of, 415-434 
dividends, 435 
steps in calculating, 417 
Net returns, 

percentage to capitalization, 182 
New York, New Haven and Hart- 
ford R.R., 
report on, by Interstate Com- 
merce Commission, 40 
New York World, 

management of, 41 
Non-competitive companies, 51 
Non-cumulative preferred stock 
dividends, 71 



556 



INDEX 



"Non-stock" corporations, 47 
Northern Pacific, 
annual meeting in 1914, 100 
insolvency of, 61 
Notes, in 
advances on, 408 
registered, 117 
short-term, 

selling price, 129 
sold to public, 127 
use in financial crisis, 128 
sold to brokers, 116 



Office, principal, of corporation, 30 
Officers, 

abuses by, 500 

as directors, 39 

contracts that benefit, 502 

exploitation by, 499-506 

misuse of inside information, 504 
Operating expenses, 428 

determination of, 421 
Operating ratios, 495 
Organization (See also "Reorgan- 
ization") 

expenses, capitalized, 178 
Organizations, business, 

basic types of, 11 

under German law, 23 

under Latin law, 22 
Overcapitalization, 92 
Owned capital (See "Capital") 
Ownership, 

continuity of, 56 

corporation, liability of, 54 

distribution of, 54 

transfer of, 54 



Participating bonds, 158 
Participating preferred stock, 82 
Partnership, 14 
advantages, 15 



disadvantages, 16 

incorporating, 221 
advantages, 55 

limited, 18 
Par value of stock, 88 
Patents, valuation of, 191 
Pears, A. & F., Ltd., 

combining with Lever Bros., Ltd., 
279 
Pennsylvania Railroad Company, 

number of stockholders, 37 

surplus account of, 474 
Personal property, as collateral, 121 
Porto Rican American Tobacco 
Company, 

dividend record, 448 
Preferred stock, 

conversion into common, 81 

dividend rate, 71 

dividend rights, 80 

general characteristics, 82 

origin of, 75 

participating, 82 

prior claim as to assets, 74 

prior claim as to dividends, 74 

prior claim as to voting, 74 

protection of, 76 

use by industrials, 75 

use by railroads, 75 

uses of, 75 

voting power of, 79 
Principles of financing, i-io 
Proctor and Gamble, 

dividend record, 447 
Profits (See also "Income") 

estimated, 420 

of promoter, 260 

variability of, 442 
Promoter, 250-264 

business executive as, 254 

engineering firm as, 252 

financial plan of, 255 

forming a combination, 269 

legal status of, 256 



INDEX 



557 



Promoter — continued 

professional, 250 

profits of, 260 

protection of, 242 

risks of, 258 
Promoting combinations, 265-200 
(See also "Combinations") 

basis of, 275 

difficulties, 269 

fields for, 267 

for greater efficiency, 289 

industrial, 265 

investigation, 273 

management of combination, 289 

small, analysis of, 282 

to secure control, 286 
Promotion, 229-249 (See also 
"Promoter," 'Promoting 

combinations," and "Combin- 
ations") 

"assembling" a proposition, 240 

examples of, 262 

fields for combination, 267 

foresight in providing funds, 
246 

investigation, stages of, 230 

preliminary analysis, 232 

preliminary financing, 244 

profits of, 260 

protection of promoter, 242 

purchase outright of separate 
units, 242 

risks of, 258 

scope of investigation, 234 

three steps in, 229 

working capital required, 247 
Proprietorship, sole, 12 
Prospectus, 

" in selling securities, 313 
Protection, 

of promoter, 242 
Proxies, 99 
Public financing, 

relation to business financing, 4 



Publicity, 

factor in making a market, 334 

power of, preventing exploita- 
tion, 512 
Public service companies, 

capitalization of, 199 
Purchase, 

terms of, 388 



Railroad, 

capitalization, per mile, 215 

financial plan for, 224 

preferred stock of, 75 
Ratio, 

operating, 495 
Receiver (See also "Receiver- 
ship") 

powers and duties, 525 
Receivership, 514-528 

conflicting, 520 

instances of voluntary dissolu- 
tion, 522 

kinds of bankruptcy, 524 

origin and nature of, 520 

origin and nature of bankruptcy, 
523 

powers and duties of receiver, 525 

receiver's certificates, 526 

results of, 526 

voluntary dissolution, 521 
Reconstruction (See "Reorganiza- 
tion") 
Redemption of preferred stock, 

76, 81 
Registered stock certificates, 87 
Registrar as check on transfer 

agent, 69 
Regulations, internal, 

of corporation, 33 
Reorganization, 529-545 

American Woolen Company, 542 

conflict of interests in, 530 

effect on financial structure, 541 



558 



INDEX 



Reorganization — continued 

formation of committees, 501 

for special purpose's, 542 

procedure in, 534 

purpose of, 529 

railroad, reducing fixed charges, 
539 

raising fresh capital, 536 

reducing fixed charges, 538 

to secure control, 544 

use of preferred stock, 75 
Repairs, 371 

reserves for, 425 
Report, annual, 35 
Reserve, surplus, 465 
Reserves, 422-427 
"Right," subscription, 

example of, 300 

figuring value of, 304 

grant of, 298 

making use of, 306 
Risks, 

distribution of, in underwriting, 

341 
of promoter, 258 
Rock Island Company, 

combination to secure control, 286 
investments of, 376 



Salaries, exorbitant, 

form of exploitation, 501 
Sales, 
gross, percentage of, to capitali- 
zation, 181 
instalment, 
financing of, 398 
three ways of financing, 404 
working capital required, 401 
terms of, 392 
"Scalpers" on stock exchange, 

332 
Scrip dividends, 458 



Securities, 

adaptation of, to market, 209 

selling, 291-318 
Security dealers, 

classes of, 319, 326 
Security issues, 

forms of, 219 

relation to assets, 218 

the choosing of, 212 
Selling expense, 

of securities, 325 
Selling securities, 

advertising, 311 

at auction, 308 

direct, 291-318 

expense of, 322-325 

finding prospective buyers, 310 

grant of subscription "rights," 
298 

limitation of sale through dealers, 

324 

limitation of sale through stock 
exchange, 336 

limitations of direct sale, 316 

making a market on stock ex- 
change, 334 

methods of, 291 

on stock exchange, 328 

prospectus, 313 

"tender" method of, 308 

through brokers, 321 

through dealers, 319-338 

to customers and employees, 294 

to stockholders, 292 
Shareholders (See "Stockholders") 
Shares (See "Stock") 
Sinking funds, 161-171 

for redemption of preferred 
stock, 76 
Smith, Adam, 59 
Societe anonyme, 2.2 
Societe en commandite, 22 
Societe en nom collectif, 22 
Sources of capital funds, 201-228 



INDEX 



559 



Southern Land Company, 

profits of the promoter, 257 
Speculative, 

dealings, importance of, 332 

public, as source of capital funds, 
203 

underwriting, 348 
Speculators, 

on stock exchange, 332 
Standard Rope and Twine Com- 
pany, 

contracts benefiting officers, 502 
Standards (See "Financial stand- 
ards") 
State, grant of powers to corpora- 
tions, 27 
Statements, 

certified, basis for loans, 124 

financial, required for bank credit, 
124 

misleading, 508 
Sterling Gum Company, 

preparing the market for a stock 
issue, 334 
Stetson, J. B., Co., 

dividend record, 446 
Stock, 

adaptation of, to market, 209 

as collateral, 120 

as dividends, 459 

capitalization of surplus, 197 

"assenting," 85 

assessment on, in reorganization, 
602 

bonus, 91 

"broken lot," 67 

certificates of, 68, 86 

common, 68 

corporation dealing in its own, 69 

deferred, 83 

distinguished from shares, 67 

dividends, cumulative, 71 

dividends, non-cumulative, 71 

founders', 83 



full-paid, 89 

issue, 

choosing the right kind, 212 
handling of, by broker, 320 
relation to gross earnings, 

514 
management shares, 83 
partly paid, 89 

liability of, 90 
par value, 88 

preferred, 68 (See also "Pre- 
ferred stock") 

as to assets, 73 

as to dividends, 73 

protection of, 76 

rate of dividends, 71 

redemption of, 76 

voting rights, 79 
selling (See also "Selling secur- 
ities") 

of smaller corporations, 208 

on stock exchange, 328 
special forms of, 83, 219 
special provisions, 219 
subscription privilege to, 299 
transfer of, 68 
watered, 92 

wide distribution of, 206 
without par value, 95 
Stock exchange, 
cost of seats, 330 
limitation of sale through, 336 
London, 331 
making a market, 334 
methods, 328 
Stockholders, 
duties, 34 
establishing cordial relations with, 

292 
exploitation by, 507-513 
meetings, 99 
minority, squeezing, 508 
misleading- statements to, 508 
rights, 34 



5 6 ° 



INDEX 



Stockholders — continued 

subscription privilege, 299 

tiring out, methods of, 511 
Submarine Boat Corporation, 

adjustment of capitalization to 
earnings, 185 
Subscription privileges, 

grant of, 298 

objections to, 303 
Subsidiary corporations, 

advantages of, 53 

use of, 52 
Surplus, 465-481 

accumulating, 471 

as a source of capital, 478 ' 

capitalization by stock dividends, 
197 

five sources of, 466 

hidden, 479 

paying dividends from, 450 
Surplus fund, 465 
Surplus reserve, 465 
Syndicate agreements, 345 
Syndicates, underwriting, 341 

commissions of, 348 



Tangible assets, 

represented by bonds and pre- 
ferred stock, 75 
Taxation of corporations, 59 
Tax bills, 

non-commercial character of, 411 
Trade acceptances, 407 
Trade credit, in 
Transfer agent, 69 
Transfer of stock, 68 
Trust companies, 

as registrar and transfer agent, 

69 

Trusts, form of combination, 50 

Turnover, 495 

determining rapidity of, 385 
influence on working capital, 384 



U 

Underwriting, 339-353 
importance of, 340 
origin of, 339 
speculative, 348 
syndicates, 341 
agreements, 345 
commissions of, 348 
Underwriting houses, 
community of interest among, 

343 
Union Pacific Railroad Company, 
example of subscription "right," 
300 
United Drug Company, 

sale of stock to employees, 296 
United States Leather Company, . 

promotion of, 275 
United States Realty and Construc- 
tion Company, 
example of promotion, 263 
syndicate agreement with, 

349 

United States Shipbuilding Com- 
pany, 

promotion of, 259, 350 
United States Steel Corporation, 

number of stockholders, 37 

overcapitalization of, 93 
"Unloading," 

by officers, 504 
Unskilful business financing, 1 
Utility corporations, 

capitalization of, 199 



Voluntary associations, 21 
Voting, 

cumulative, 97 

methods of, 96 

stock preferred, 74 
Voting power, 

Canada, preferred stock, 79 









INDEX 



;6i 



Voting power — continued 

distribution by use of preferred 
stock, 76 
Voting stock, 

restriction of, 83 
Voting trust, 102 



W 

Warehouse receipts, 
as collateral, 121 

Watered stock, 92 

Westinghouse Electric and Manu- 
facturing Company, 
"assenting" stock of, 85 
reckless use of capital funds, 

357 
Westinghouse, George, 
inventor and organizer, 2 



Working capital, 

affected by length of period of 

manufacture, 381 
affected by terms of purchase, 388 
calculating requirements of, 380- 

414 
effect of seasonal changes, 412 
factors that affect, 361 
factors to be considered, 380 
influenced by terms of sale, 392 
in instalment selling, 401 
lack of, cause of insolvency, 516 
month-by-month calculations, 413 
necessity for adequate, 357 
providing, 355 
relation to total, 490 
relation to turnover, 384 
relative amount of, to fixed, 378 
required, in new proposition, 247 






R1959 



